(11) INCOME TAXES

PHI and the majority of its subsidiaries file a consolidated federal income tax return. Federal income taxes are allocated among PHI and the subsidiaries included in its consolidated group pursuant to a written tax sharing agreement that was approved by the SEC in 2002 in connection with the establishment of PHI as a public utility holding company. Under this tax sharing agreement, PHI’s consolidated federal income tax liability is allocated based upon PHI’s and its subsidiaries’ separate taxable income or loss.

The provision for consolidated income taxes, reconciliation of consolidated income tax expense, and components of consolidated deferred tax liabilities (assets) are shown below.

Provision for Consolidated Income Taxes – Continuing Operations


	For the Year Ended December 31,
	2013			2012			2011
	*(millions of dollars)*
Current Tax (Benefit) Expense
Federal	$	(128	)	$	(166	)	$	(72	)
State and local		(9	)		(40	)		12

Total Current Tax (Benefit) Expense		(137	)		(206	)		(60	)

Deferred Tax Expense (Benefit)
Federal		393			254			163
State and local		65			58			15
Investment tax credit amortization		(2	)		(3	)		(4	)

Total Deferred Tax Expense		456			309			174

Total Consolidated Income Tax Expense Related to Continuing Operations	$	319		$	103		$	114

Reconciliation of Consolidated Income Tax Expense – Continuing Operations


	For the Year Ended December 31,
	2013					2012					2011
	*(millions of dollars)*
Income tax at Federal statutory rate	$	150		35.0	%	$	112		35.0	%	$	118		35.0	%
Increases (decreases) resulting from:
State income taxes, net of Federal effect		27		6.3	%		19		6.0	%		23		6.7	%
Asset removal costs		(14	)	(3.3	)%		(11	)	(3.4	)%		(7	)	(2.1	)%
Change in estimates and interest related to uncertain and effectively settled tax positions		56		13.1	%		(8	)	(2.6	)%		(5	)	(1.6	)%
Establishment of valuation allowances related to deferred tax assets		101		23.5	%		—		—			—		—
Other, net		(1	)	(0.2	)%		(9	)	(2.9	)%		(15	)	(4.1	)%

Consolidated Income Tax Expense Related to Continuing Operations	$	319		74.4	%	$	103		32.1	%	$	114		33.9	%

Year ended December 31, 2013

PHI’s consolidated effective income tax rate for the year ended December 31, 2013 of 74.4% reflects a charge of $56 million for changes in estimates and interest related to uncertain and effectively settled tax positions recorded in the first quarter of 2013 and the establishment of valuation allowances of $101 million in the first quarter of 2013 against certain deferred tax assets in PCI, which is now included in Corporate and Other. The income tax charge of $56 million is primarily related to the anticipated additional interest expense on estimated federal and state income tax obligations that was allocated to PHI’s continuing operations resulting from a change in assessment of tax benefits associated with the former cross-border energy lease investments of PCI.

Between 1990 and 1999, PCI, through various subsidiaries, entered into certain transactions involving investments in aircraft and aircraft equipment, railcars and other assets. In connection with these transactions, PCI recorded deferred tax assets in prior years of $101 million in the aggregate. Following events that took place during the first quarter of 2013, which included (i) court decisions in favor of the IRS with respect to both Consolidated Edison’s cross-border lease transaction (as discussed in Note (19), “Discontinued Operations – Cross-Border Energy Lease Investments”) and another taxpayer’s structured transactions, (ii) the change in PHI’s tax position with respect to the tax benefits associated with its cross-border energy leases, and (iii) PHI’s decision in March 2013 to begin to pursue the early termination of its remaining cross-border energy lease investments (which represented a substantial portion of the remaining assets within PCI) without the intent to reinvest these proceeds in income-producing assets, management evaluated the likelihood that PCI would be able to realize the $101 million of deferred tax assets in the future. Based on this evaluation, PCI established valuation allowances against these deferred tax assets totaling $101 million in the first quarter of 2013. Further, during the fourth quarter of 2013, in light of additional court decisions in favor of the IRS involving other taxpayers, and after consideration of all relevant factors, management determined that it would abandon the further pursuit of these deferred tax assets, and these assets totaling $101 million were charged off against the previously established valuation allowances.

Year ended December 31, 2012

PHI’s consolidated effective income tax rate for the year ended December 31, 2012 of 32.1% includes income tax benefits totaling $8 million related to uncertain and effectively settled tax positions, primarily due to the effective settlement with the IRS in the first quarter of 2012 with respect to the methodology used historically to calculate deductible mixed service costs and the expiration of the statute of limitations associated with an uncertain tax position in Pepco. The rate for the year ended December 31, 2012 also reflects an increase in deductible asset removal costs for Pepco in 2012 related to a higher level of asset retirements.

Year ended December 31, 2011

PHI’s consolidated effective income tax rate for the year ended December 31, 2011 of 33.9% includes income tax benefits totaling $5 million related to uncertain and effectively settled tax positions. In 2011, PHI reached a settlement with the IRS with respect to interest due on its federal tax liabilities related to the November 2010 audit settlement for years 1996 through 2002. In connection with this agreement, PHI reallocated certain amounts that have been on deposit with the IRS since 2006 among liabilities in the settlement years and subsequent years and recorded the tax benefits, primarily in the second quarter of 2011.

In addition, as discussed further in Note (15), “Commitments and Contingencies – District of Columbia Tax Legislation,” on June 14, 2011, the Council of the District of Columbia approved the Fiscal Year 2012 Budget Support Act of 2011 (the Budget Support Act). The Budget Support Act includes a provision that requires corporate taxpayers in the District of Columbia to calculate taxable income allocable or apportioned to the District by reference to the income and apportionment factors applicable to commonly controlled entities organized within the United States that are engaged in a unitary business. Previously, only the income of companies with direct nexus to the District of Columbia was taxed. As a result of the change, during 2011 PHI recorded additional state income tax expense of $2 million.

Components of Consolidated Deferred Tax Liabilities (Assets)


	At December 31,
	2013			2012
	*(millions of dollars)*
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	2,628		$	2,299
Deferred electric service and electric restructuring liabilities		91			110
Cross-border energy lease investments		(6	)		756
Federal and state net operating losses		(350	)		(394	)
Valuation allowances on state net operating losses		21			21
Pension and other postretirement benefits		135			128
Deferred taxes on amounts to be collected through future rates		75			58
Other (a)		285			204	(b)

Total Deferred Tax Liabilities, net		2,879			3,182	(b)
Deferred tax assets included in Current Assets		51			28
Deferred tax liabilities included in Other Current Liabilities		(2	)		(2	)

Total Consolidated Deferred Tax Liabilities, net non-current	$	2,928		$	3,208	(b)

(a)

PCI established valuation allowances against certain of these other deferred taxes totaling $101 million in the first quarter of 2013. Management determined during the fourth quarter of 2013 to abandon the further pursuit of the related deferred tax assets and, accordingly, these assets were charged off against the valuation allowances.

(b)

The amounts for Other, Total Deferred Tax Liabilities, net and Total Consolidated Deferred Tax Liabilities, net non-current, are presented after the effect of the revision to prior period financial statements discussed in Note (2), “ Significant Accounting Policies – Revision to Prior Period Financial Statements.”

The net deferred tax liability represents the tax effect, at presently enacted tax rates, of temporary differences between the financial statement basis and tax basis of assets and liabilities. The portion of the net deferred tax liability applicable to PHI’s utility operations, which has not been reflected in current service rates, represents income taxes recoverable through future rates, net, and is recorded as a Regulatory asset on the balance sheet. Federal and state net operating losses generally expire over 20 years from 2029 to 2032.

The Tax Reform Act of 1986 repealed the investment tax credit for property placed in service after December 31, 1985, except for certain transition property. Investment tax credits previously earned on Pepco’s, DPL’s and ACE’s property continue to be amortized to income over the useful lives of the related property.

Reconciliation of Beginning and Ending Balances of Unrecognized Tax Benefits


	2013			2012			2011
	*(millions of dollars)*
Balance as of January 1,	$	200		$	357		$	395
Tax positions related to current year:
Additions		3			1			2
Reductions		—			—			—
Tax positions related to prior years:
Additions		646	(a)		79			20
Reductions		(12	)		(235	)(b)		(57	)
Settlements		(6	)		(2	)		(3	)

Balance as of December 31,	$	831		$	200		$	357

(a)	These additions of unrecognized tax benefits in 2013 primarily relate to the cross-border energy lease investments of PCI.

(b)	These reductions of unrecognized tax benefits in 2012 primarily relate to a resolution reached with the IRS for determining deductible mixed service costs for additions to property, plant and equipment.

Unrecognized Benefits That, If Recognized, Would Affect the Effective Tax Rate

Unrecognized tax benefits are related to tax positions that have been taken or are expected to be taken in tax returns that are not recognized in the financial statements because management has either measured the tax benefit at an amount less than the benefit claimed or expected to be claimed, or has concluded that it is not more likely than not that the tax position will be ultimately sustained. For the majority of these tax positions, the ultimate deductibility is highly certain, but there is uncertainty about the timing of such deductibility. Unrecognized tax benefits at December 31, 2013 included $9 million that, if recognized, would lower the effective tax rate.

Interest and Penalties

PHI recognizes interest and penalties relating to its uncertain tax positions as an element of income tax expense. For the years ended December 31, 2013, 2012 and 2011, PHI recognized $125 million of pre-tax interest expense ($75 million after-tax), $23 million of pre-tax interest income ($14 million after-tax), and $23 million of pre-tax interest income ($14 million after-tax), respectively, as a component of income tax expense related to continuing and discontinued operations. As of December 31, 2013, 2012 and 2011, PHI had accrued interest receivable of $2 million, accrued interest receivable of $10 million and accrued interest payable of $4 million, respectively, related to effectively settled and uncertain tax positions.

Possible Changes to Unrecognized Tax Benefits

It is reasonably possible that the amount of unrecognized tax benefits with respect to PHI’s uncertain tax positions will significantly increase or decrease within the next 12 months. In order to mitigate the cost of continued litigation of tax matters related to the former cross-border energy lease investments, PHI and its subsidiaries have entered into discussions with the IRS with the intention of seeking a settlement of all tax issues for open tax years 2001 through 2011. PHI currently believes that it is possible that a settlement with the IRS may be reached in 2014, which could significantly impact the balances of unrecognized tax benefits and the related interest accruals. At this time, it is estimated that there will be a $700 million to $800 million decrease in unrecognized tax benefits within the next 12 months. See Note (15), “Commitments and Contingencies – PHI’s Cross-Border Energy Lease Investments,” for additional discussion.

Tax Years Open to Examination

PHI’s federal income tax liabilities for Pepco legacy companies for all years through 2002, and for Conectiv legacy companies for all years through 2002, have been determined by the IRS, subject to adjustment to the extent of any net operating loss or other loss or credit carrybacks from subsequent years. PHI has not reached final settlement with the IRS with respect to the cross-border energy lease deductions. The open tax years for the significant states where PHI files state income tax returns (District of Columbia, Maryland, Delaware, New Jersey, Pennsylvania and Virginia) are the same as for the Federal returns.

Final IRS Regulations on Repair of Tangible Property

In September 2013, the IRS issued final regulations on expense versus capitalization of repairs with respect to tangible personal property. The regulations are effective for tax years beginning on or after January 1, 2014, and provide an option to early adopt the final regulations for tax years beginning on or after January 1, 2012. It is expected that the IRS will issue revenue procedures that will describe how taxpayers may implement the final regulations. The final repair regulations retain the operative rule that the Unit of Property for network assets is determined by the taxpayer’s particular facts and circumstances except as provided in published guidance. In 2012, with the filing of its 2011 tax return, PHI filed a request for an automatic change in accounting method related to repairs of its network assets in accordance with IRS Revenue Procedure 2011-43. PHI does not expect the effects of the final regulations to be significant and will continue to evaluate the impact of the new guidance on its consolidated financial statements.

Other Taxes

Other taxes for continuing operations are shown below. The annual amounts include $422 million, $426 million and $445 million for the years ended December 31, 2013, 2012 and 2011, respectively, related to Power Delivery, which are recoverable through rates.


	2013		2012		2011
	*(millions of dollars)*
Gross Receipts/Delivery	$	133	$	135	$	145
Property		77		75		71
County Fuel and Energy		153		160		170
Environmental, Use and Other		65		62		65

Total	$	428	$	432	$	451

Income Taxes

(10) INCOME TAXES

Pepco, as a direct subsidiary of PHI, is included in the consolidated federal income tax return of PHI. Federal income taxes are allocated to Pepco pursuant to a written tax sharing agreement that was approved by the Securities and Exchange Commission in connection with the establishment of PHI as a holding company. Under this tax sharing agreement, PHI’s consolidated federal income tax liability is allocated based upon PHI’s and its subsidiaries’ separate taxable income or loss.

The provision for income taxes, reconciliation of income tax expense, and components of deferred income tax liabilities (assets) are shown below.

Provision for Income Taxes


	For the Year Ended December 31,
	2013			2012			2011
	*(millions of dollars)*
Current Tax Benefit
Federal	$	(39	)	$	(84	)	$	(19	)
State and local		(1	)		(27	)		(16	)

Total Current Tax Benefit		(40	)		(111	)		(35	)

Deferred Tax Expense (Benefit)
Federal		96			127			54
State and local		24			33			19
Investment tax credit amortization		(1	)		(1	)		(2	)

Total Deferred Tax Expense		119			159			71

Total Income Tax Expense	$	79		$	48		$	36

Reconciliation of Income Tax Expense


	For the Year Ended December 31,
	2013					2012					2011
	*(millions of dollars)*
Income tax at Federal statutory rate	$	80		35.0	%	$	61		35.0	%	$	47		35.0	%
Increases (decreases) resulting from:
State income taxes, net of Federal effect		13		5.7	%		10		5.7	%		8		5.5	%
Asset removal costs		(14	)	(6.1	)%		(11	)	(6.3	)%		(7	)	(5.0	)%
Change in estimates and interest related to uncertain and effectively settled tax positions		(3	)	(1.3	)%		(11	)	(6.3	)%		(9	)	(6.6	)%
Other, net		3		1.2	%		(1	)	(0.5	)%		(3	)	(2.2	)%

Income Tax Expense	$	79		34.5	%	$	48		27.6	%	$	36		26.7	%

Year ended December 31, 2013

Pepco’s effective income tax rate for the year ended December 31, 2013 of 34.5% reflects income tax benefits totaling $3 million related to uncertain and effectively settled tax positions.

On January 9, 2013, the U.S. Court of Appeals for the Federal Circuit issued an opinion in Consolidated Edison Company of New York, Inc. & Subsidiaries v. United States (to which Pepco is not a party) that disallowed tax benefits associated with Consolidated Edison’s cross-border lease transaction. As a result of the court’s ruling in this case, PHI determined in the first quarter of 2013 that it could no longer support its current assessment with respect to the likely outcome of tax positions associated with its cross-border energy lease investments held by its wholly-owned subsidiary Potomac Capital Investment Corporation, and PHI recorded an after-tax charge of $377 million in the first quarter of 2013. Included in the $377 million charge was an after-tax interest charge of $54 million and this amount was allocated to each member of PHI’s consolidated group as if each member was a separate taxpayer, resulting in Pepco recording a $5 million (after-tax) interest benefit in the first quarter of 2013.

Year ended December 31, 2012

Pepco’s effective income tax rate for the year ended December 31, 2012 of 27.6% primarily reflects tax benefits related to asset removal costs and changes in estimates and interest related to uncertain and effectively settled tax positions.

During 2012, Pepco recorded income tax benefits of $10 million related to uncertain and effectively settled tax positions primarily due to the effective settlement with the Internal Revenue Service (IRS) with respect to the methodology used historically to calculate deductible mixed service costs and the expiration of the statute of limitations associated with an uncertain tax position.

The effective income tax rate also reflects an increase in deductible asset removal costs for Pepco in 2012 related to a higher level of asset retirements.

Year ended December 31, 2011

Pepco’s effective income tax rate for the year ended December 31, 2011 of 26.7% includes income tax benefits totaling $9 million related to uncertain and effectively settled tax positions.

During 2011, PHI reached a settlement with the IRS with respect to interest due on its federal tax liabilities related to the November 2010 audit settlement for years 1996 through 2002. In connection with this agreement, PHI reallocated certain amounts that have been on deposit with the IRS since 2006 among liabilities in the settlement years and subsequent years. Primarily related to the settlement and reallocations, Pepco recorded a tax benefit of $5 million (after-tax) in the second quarter of 2011.

During the third quarter of 2011, Pepco recalculated interest on its uncertain tax positions for open tax years based on different assumptions related to the application of its deposit made with the IRS in 2006. This resulted in an additional tax expense of $1 million (after-tax).

During 2011, Pepco decided to adopt the safe harbor tax accounting method for certain repairs pursuant to IRS guidance. As a result, Pepco reversed $23 million of previously recorded liabilities on uncertain tax positions and reversed the associated $1 million of accrued interest.

In May 2011, Pepco received refunds of approximately $5 million and recorded tax benefits of approximately $4 million (after-tax) related to the filing of amended state tax returns. These amended returns reduced state taxable income due to an increase in tax basis on certain prior years’ asset dispositions.

Components of Deferred Income Tax Liabilities (Assets)


	At December 31,
	2013			2012
	*(millions of dollars)*
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	1,240		$	1,105
Pension and other postretirement benefits		105			111
Deferred taxes on amounts to be collected through future rates		43			28
Federal and state net operating losses		(169	)		(174	)
Other		145			140

Total Deferred Tax Liabilities, net		1,364			1,210
Deferred tax assets included in Current Assets		48			9

Total Deferred Tax Liabilities, net non-current	$	1,412		$	1,219

The net deferred tax liability represents the tax effect, at presently enacted tax rates, of temporary differences between the financial statement basis and tax basis of assets and liabilities. The portion of the net deferred tax liability applicable to Pepco’s operations, which has not been reflected in current service rates, represents income taxes recoverable through future rates, net, and is recorded as a regulatory asset on the balance sheet. No valuation allowance for deferred tax assets was required or recorded at December 31, 2013 and 2012. Federal and state net operating losses generally expire over 20 years from 2029 to 2032.

The Tax Reform Act of 1986 repealed the investment tax credit for property placed in service after December 31, 1985, except for certain transition property. Investment tax credits previously earned on Pepco’s property continue to be amortized to income over the useful lives of the related property.

Reconciliation of Beginning and Ending Balances of Unrecognized Tax Benefits


	2013			2012			2011
	*(millions of dollars)*
Balance as of January 1	$	91		$	173		$	190
Tax positions related to current year:
Additions		1			—			—
Reductions		—			—			—
Tax positions related to prior years:
Additions		12			60			12
Reductions		(3	)		(142	)(a)		(26	)
Settlements		—			—			(3	)

Balance as of December 31	$	101		$	91		$	173

(a)	These reductions of unrecognized tax benefits in 2012 primarily relate to a resolution reached with the IRS for determining deductible mixed service costs for additions to property, plant and equipment.

Unrecognized Benefits That, If Recognized, Would Affect the Effective Tax Rate

Unrecognized tax benefits are related to tax positions that have been taken or are expected to be taken in tax returns that are not recognized in the financial statements because management has either measured the tax benefit at an amount less than the benefit claimed, or expected to be claimed, or has concluded that it is not more likely than not that the tax position will be ultimately sustained. For the majority of these tax positions, the ultimate deductibility is highly certain, but there is uncertainty about the timing of such deductibility. At December 31, 2013, Pepco had less than $1 million of unrecognized tax benefits that, if recognized, would lower the effective tax rate.

Interest and Penalties

Pepco recognizes interest and penalties relating to its uncertain tax positions as an element of income tax expense. For the years ended December 31, 2013, 2012 and 2011, Pepco recognized $5 million of pre-tax interest income ($3 million after-tax), $18 million of pre-tax interest income ($11 million after-tax), and $8 million of pre-tax interest income ($5 million after-tax), respectively, as a component of income tax expense. As of December 31, 2013, 2012 and 2011, Pepco had accrued interest receivable of $9 million, accrued interest receivable of $5 million and accrued interest payable of $6 million, respectively, related to effectively settled and uncertain tax positions.

Possible Changes to Unrecognized Tax Benefits

It is reasonably possible that the amount of the unrecognized tax benefit with respect to some of Pepco’s uncertain tax positions will significantly increase or decrease within the next 12 months. PHI and its subsidiaries have entered into discussions with the IRS with the intention of seeking a settlement of all tax issues of Pepco for open tax years 2001 through 2011. PHI currently believes that it is possible that a settlement with the IRS may be reached in 2014, which could significantly impact the balances of unrecognized tax benefits and the related interest accruals of Pepco. At this time, it is estimated that there will be a $65 million to $85 million decrease in unrecognized tax benefits within the next 12 months.

Tax Years Open to Examination

Pepco, as a direct subsidiary of PHI, is included on PHI’s consolidated Federal income tax return. Pepco’s federal income tax liabilities for all years through 2002 have been determined, subject to adjustment to the extent of any net operating loss or other loss or credit carrybacks from subsequent years. The open tax years for the significant states where Pepco files state income tax returns (District of Columbia and Maryland) are the same as for the Federal returns. As a result of the final determination of these years, Pepco filed amended state returns requesting $20 million in refunds which are subject to review by the various states. To date, Pepco has received $4 million in refunds and legislation has been enacted in the District of Columbia (subject to a 30-day Congressional review period before becoming law) which will allow for the recovery of the remaining $16 million in refunds.

Final IRS Regulations on Repair of Tangible Property

In September 2013, the IRS issued final regulations on expense versus capitalization of repairs with respect to tangible personal property. The regulations are effective for tax years beginning on or after January 1, 2014, and provide an option to early adopt the final regulations for tax years beginning on or after January 1, 2012. It is expected that the IRS will issue revenue procedures that will describe how taxpayers may implement the final regulations. The final repair regulations retain the operative rule that the Unit of Property for network assets is determined by the taxpayer’s particular facts and circumstances except as provided in published guidance. In 2012, with the filing of its 2011 tax return, PHI filed a request for an automatic change in accounting method related to repairs of its network assets in accordance with IRS Revenue Procedure 2011-43. Pepco does not expect the effects of the final regulations to be significant and will continue to evaluate the impact of the new guidance on its financial statements.

Other Taxes

Taxes other than income taxes for each year are shown below. These amounts are recoverable through rates.


	2013		2012		2011
	*(millions of dollars)*
Gross Receipts/Delivery	$	108	$	106	$	109
Property		45		46		44
County Fuel and Energy		153		160		170
Environmental, Use and Other		62		60		59

Total	$	368	$	372	$	382

Income Taxes

(11) INCOME TAXES

DPL, as an indirect subsidiary of PHI, is included in the consolidated federal income tax return of PHI. Federal income taxes are allocated to DPL pursuant to a written tax sharing agreement that was approved by the Securities and Exchange Commission in connection with the establishment of PHI as a holding company. Under this tax sharing agreement, PHI’s consolidated federal income tax liability is allocated based upon PHI’s and its subsidiaries’ separate taxable income or loss.

The provision for income taxes, reconciliation of income tax expense, and components of deferred income tax liabilities (assets) are shown below.

Provision for Income Taxes


	For the Year Ended December 31,
	2013			2012			2011
	*(millions of dollars)*
Current Tax (Benefit) Expense
Federal	$	(8	)	$	(9	)	$	(22	)
State and local		—			(1	)		8

Total Current Tax Benefit		(8	)		(10	)		(14	)

Deferred Tax Expense (Benefit)
Federal		53			44			53
State and local		12			11			4
Investment tax credit amortization		(1	)		(1	)		(1	)

Total Deferred Tax Expense		64			54			56

Total Income Tax Expense	$	56		$	44		$	42

Reconciliation of Income Tax Expense


	For the Year Ended December 31,
	2013					2012					2011
	*(millions of dollars)*
Income tax at Federal statutory rate	$	51		35.0	%	$	41		35.0	%	$	40		35.0	%
Increases (decreases) resulting from:
State income taxes, net of Federal effect		8		5.5	%		6		5.1	%		6		5.3	%
Change in estimates and interest related to uncertain and effectively settled tax positions		—		—			—		—			(3	)	(2.7	)%
Other, net		(3	)	(1.9	)%		(3	)	(2.5	)%		(1	)	(0.4	)%

Income Tax Expense	$	56		38.6	%	$	44		37.6	%	$	42		37.2	%

Year ended December 31, 2013

On January 9, 2013, the U.S. Court of Appeals for the Federal Circuit issued an opinion in Consolidated Edison Company of New York, Inc. & Subsidiaries v. United States (to which DPL is not a party) that disallowed tax benefits associated with Consolidated Edison’s cross-border lease transaction. As a result of the court’s ruling in this case, PHI determined in the first quarter of 2013 that it could no longer support its current assessment with respect to the likely outcome of tax positions associated with its cross-border energy lease investments held by its wholly-owned subsidiary Potomac Capital Investment Corporation, and PHI recorded an after-tax charge of $377 million in the first quarter of 2013. Included in the $377 million charge was an after-tax interest charge of $54 million and this amount was allocated to each member of PHI’s consolidated group as if each member was a separate taxpayer, resulting in DPL recording a $1 million interest benefit in the first quarter of 2013.

Year ended December 31, 2011

During 2011, PHI reached a settlement with the Internal Revenue Service (IRS) with respect to interest due on its federal tax liabilities related to the November 2010 audit settlement for years 1996 through 2002. In connection with this agreement, PHI reallocated certain amounts that have been on deposit with the IRS since 2006 among liabilities in the settlement years and subsequent years. Primarily related to the settlement and reallocations, DPL recorded a $4 million (after-tax) interest benefit. This is partially offset by adjustments recorded in the third quarter of 2011 related to DPL’s settlement with the state taxing authorities resulting in $1 million (after-tax) of additional tax expense and the recalculation of interest on its uncertain tax positions for open tax years based on different assumptions related to the application of its deposit made with the IRS in 2006 resulting in an additional tax expense of $1 million (after-tax).

Components of Deferred Income Tax Liabilities (Assets)


	As of December 31,
	2013			2012
	*(millions of dollars)*
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	712		$	623
Deferred taxes on amounts to be collected through future rates		16			15
Federal and state net operating losses		(125	)		(80	)
Pension and other postretirement benefits		80			85
Electric restructuring liabilities		(5	)		(5	)
Other		80			49

Total Deferred Tax Liabilities, net		758			687
Deferred tax assets included in Current Assets		59			11
Deferred tax liabilities included in Other Current Liabilities		(1	)		(1	)

Total Deferred Tax Liabilities, net non-current	$	816		$	697

The net deferred tax liability represents the tax effect, at presently enacted tax rates, of temporary differences between the financial statement basis and tax basis of assets and liabilities. The portion of the net deferred tax liability applicable to DPL’s operations, which has not been reflected in current service rates, represents income taxes recoverable through future rates, net, and is recorded as a regulatory asset on the balance sheet. No valuation allowance for deferred tax assets was required or recorded at December 31, 2013 and 2012. Federal and state net operating losses generally expire over 20 years from 2029 to 2032.

The Tax Reform Act of 1986 repealed the investment tax credit for property placed in service after December 31, 1985, except for certain transition property. Investment tax credits previously earned on DPL’s property continue to be amortized to income over the useful lives of the related property.

Reconciliation of Beginning and Ending Balances of Unrecognized Tax Benefits


	2013		2012			2011
	*(millions of dollars)*
Balance as of January 1	$	9	$	35		$	40
Tax positions related to current year:
Additions		—		—			—
Reductions		—		—			—
Tax positions related to prior years:
Additions		—		—			7
Reductions		—		(26	)(a)		(12	)
Settlements		—		—			—

Balance as of December 31	$	9	$	9		$	35

(a)	These reductions of unrecognized tax benefits in 2012 primarily relate to a resolution reached with the IRS for determining deductible mixed service costs for additions to property, plant and equipment.

Unrecognized Benefits That, If Recognized, Would Affect the Effective Tax Rate

Unrecognized tax benefits are related to tax positions that have been taken or are expected to be taken in tax returns that are not recognized in the financial statements because management has either measured the tax benefit at an amount less than the benefit claimed, or expected to be claimed, or has concluded that it is not more likely than not that the tax position will be ultimately sustained. For the majority of these tax positions, the ultimate deductibility is highly certain, but there is uncertainty about the timing of such deductibility. At December 31, 2013, DPL had $1 million of unrecognized tax benefits that, if recognized, would lower the effective tax rate.

Interest and Penalties

DPL recognizes interest and penalties relating to its uncertain tax positions as an element of income tax expense. For the years ended December 31, 2013, 2012 and 2011, DPL recognized less than $1 million of pre-tax interest income, less than $1 million of pre-tax interest income and $6 million of pre-tax interest income ($4 million after-tax), respectively, as a component of income tax expense. As of December 31, 2013, 2012 and 2011, DPL had accrued interest receivable of $2 million, accrued interest receivable of $1 million and accrued interest receivable of $1 million, respectively, related to effectively settled and uncertain tax positions.

Possible Changes to Unrecognized Tax Benefits

It is reasonably possible that the amount of the unrecognized tax benefit with respect to some of DPL’s uncertain tax positions will significantly increase or decrease within the next 12 months. PHI and its subsidiaries have entered into discussions with the IRS with the intention of seeking a settlement of all tax issues of DPL for open tax years 2001 through 2011. PHI currently believes that it is possible that a settlement with the IRS may be reached in 2014, which could significantly impact the balances of unrecognized tax benefits and the related interest accruals of DPL. At this time, it is estimated that there will be a $4 million to $6 million decrease in unrecognized tax benefits within the next 12 months.

Tax Years Open to Examination

DPL, as an indirect subsidiary of PHI, is included on PHI’s consolidated Federal tax return. DPL’s federal income tax liabilities for all years through 2002 have been determined, subject to adjustment to the extent of any net operating loss or other loss or credit carrybacks from subsequent years. The open tax years for the significant states where DPL files state income tax returns (Maryland and Delaware) are the same as for the Federal returns.

Final IRS Regulations on Repair of Tangible Property

In September 2013, the IRS issued final regulations on expense versus capitalization of repairs with respect to tangible personal property. The regulations are effective for tax years beginning on or after January 1, 2014, and provide an option to early adopt the final regulations for tax years beginning on or after January 1, 2012. It is expected that the IRS will issue revenue procedures that will describe how taxpayers may implement the final regulations. The final repair regulations retain the operative rule that the Unit of Property for network assets is determined by the taxpayer’s particular facts and circumstances except as provided in published guidance. In 2012, with the filing of its 2011 tax return, PHI filed a request for an automatic change in accounting method related to repairs of its network assets in accordance with IRS Revenue Procedure 2011-43. DPL does not expect the effects of the final regulations to be significant and will continue to evaluate the impact of the new guidance on its financial statements.

Other Taxes

Taxes other than income taxes for each year are shown below. These amounts are recoverable through rates.


	2013		2012		2011
	*(millions of dollars)*
Gross Receipts/Delivery	$	15	$	14	$	15
Property		24		21		19
Environmental, Use and Other		1		1		3

Total	$	40	$	36	$	37

Income Taxes

(10) INCOME TAXES

ACE, as an indirect subsidiary of PHI, is included in the consolidated federal income tax return of PHI. Federal income taxes are allocated to ACE pursuant to a written tax sharing agreement that was approved by the Securities and Exchange Commission in connection with the establishment of PHI as a holding company. Under this tax sharing agreement, PHI’s consolidated federal income tax liability is allocated based upon PHI’s and its subsidiaries’ separate taxable income or loss.

The provision for consolidated income taxes, reconciliation of consolidated income tax expense, and components of consolidated deferred income tax liabilities (assets) are shown below.

Provision for Consolidated Income Taxes


	For the Year Ended December 31,
	2013			2012			2011
	*(millions of dollars)*
Current Tax (Benefit) Expense
Federal	$	(23	)	$	(31	)	$	(9	)
State and local		(10	)		(12	)		1

Total Current Tax Benefit		(33	)		(43	)		(8	)

Deferred Tax Expense (Benefit)
Federal		28			46			35
State and local		25			16			7
Investment tax credit amortization		(1	)		(1	)		(1	)

Total Deferred Tax Expense		52			61			41

Total Consolidated Income Tax Expense	$	19		$	18		$	33

Reconciliation of Consolidated Income Tax Expense


	For the Year Ended December 31,
	2013					2012					2011
	*(millions of dollars)*
Income tax at Federal statutory rate	$	24		35.0	%	$	19		35.0	%	$	25		35.0	%
Increases (decreases) resulting from:
State income taxes, net of Federal effect		5		7.2	%		3		5.7	%		4		6.0	%
Change in estimates and interest related to uncertain and effectively settled tax positions		(9	)	(13.0	)%		(1	)	(1.9	)%		5		6.9	%
Plant basis adjustments		(2	)	(2.9	)%		(1	)	(1.9	)%		—		—
Investment tax credit amortization		(1	)	(1.4	)%		(1	)	(1.9	)%		(1	)	(1.3	)%
Other, net		2		2.6	%		(1	)	(1.0	)%		—		(0.8	)%

Consolidated Income Tax Expense	$	19		27.5	%	$	18		34.0	%	$	33		45.8	%

Year ended December 31, 2013

ACE’s consolidated effective income tax rate for the year ended December 31, 2013 of 27.5% includes income tax benefits totaling $9 million related to uncertain and effectively settled tax positions.

On January 9, 2013, the U.S. Court of Appeals for the Federal Circuit issued an opinion in Consolidated Edison Company of New York, Inc. & Subsidiaries v. United States (to which ACE is not a party) that disallowed tax benefits associated with Consolidated Edison’s cross-border lease transaction. As a result of the court’s ruling in this case, PHI determined in the first quarter of 2013 that it could no longer support its current assessment with respect to the likely outcome of tax positions associated with its cross-border energy lease investments held by its wholly-owned subsidiary Potomac Capital Investment Corporation, and PHI recorded an after-tax charge of $377 million in the first quarter of 2013. Included in the $377 million charge was an after-tax interest charge of $54 million and this amount was allocated to each member of PHI’s consolidated group as if each member was a separate taxpayer, resulting in ACE recording a $6 million interest benefit in the first quarter of 2013.

Year ended December 31, 2012

ACE’s consolidated effective income tax rate for the year ended December 31, 2012 of 34.0% reflects a $1 million benefit associated with the effective settlement with the Internal Revenue Service (IRS) with respect to the methodology used historically to calculate deductible mixed service costs.

Year ended December 31, 2011

ACE’s consolidated effective income tax rate for the year ended December 31, 2011 of 45.8% includes a charge totaling $5 million related to uncertain and effectively settled tax positions.

During 2011, PHI reached a settlement with the IRS with respect to interest due on its federal tax liabilities related to the November 2010 audit settlement for years 1996 through 2002. In connection with this agreement, PHI reallocated certain amounts that have been on deposit with the IRS since 2006 among liabilities in the settlement years and subsequent years. Primarily related to the settlement and reallocations, ACE has recorded a $1 million (after-tax) interest charge in the second quarter of 2011. Additionally, in the third quarter of 2011, ACE recorded a $3 million (after-tax) interest charge related to the recalculation of interest on its uncertain tax positions for open tax years using different assumptions related to the application of its deposit made with the IRS in 2006.

Components of Consolidated Deferred Income Tax Liabilities (Assets)


	As of December 31,
	2013			2012
	*(millions of dollars)*
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	627		$	538
Deferred taxes on amounts to be collected through future rates		16			15
Payment for termination of purchased power contracts with NUGs		43			47
Deferred electric service and electric restructuring liabilities		96			116
Pension and other postretirement benefits		29			34
Purchased energy		2			3
Federal and state net operating loss		(49	)		(54	)
Other		55			58

Total Deferred Tax Liabilities, net		819			757
Deferred tax assets included in Current Assets		15			10
Deferred tax liabilities included in Other Current Liabilities		(1	)		(1	)

Total Consolidated Deferred Tax Liabilities, net non-current	$	833		$	766

The net deferred tax liability represents the tax effect, at presently enacted tax rates, of temporary differences between the financial statement basis and tax basis of assets and liabilities. The portion of the net deferred tax liability applicable to ACE’s operations, which has not been reflected in current service rates, represents income taxes recoverable through future rates, net, and is recorded as a regulatory asset on the balance sheet. No valuation allowance for deferred tax assets was required or recorded at December 31, 2013 and 2012. Federal and State net operating losses generally expire over 20 years from 2029 to 2032.

The Tax Reform Act of 1986 repealed the investment tax credit for property placed in service after December 31, 1985, except for certain transition property. Investment tax credits previously earned on ACE’s property continue to be amortized to income over the useful lives of the related property.

Reconciliation of Beginning and Ending Balances of Unrecognized Tax Benefits


	2013			2012			2011
	*(millions of dollars)*
Balance as of January 1	$	17		$	79		$	83
Tax positions related to current year:
Additions		2			1			2
Reductions		—			—			—
Tax positions related to prior years:
Additions		1			8			4
Reductions		(5	)		(69	)(a)		(10	)
Settlements		(6	)		(2	)		—

Balance as of December 31	$	9		$	17		$	79

(a)	These reductions of unrecognized tax benefits in 2012 primarily relate to a resolution reached with the IRS for determining deductible mixed service costs for additions to property, plant and equipment.

Unrecognized Benefits That, If Recognized, Would Affect the Effective Tax Rate

Unrecognized tax benefits are related to tax positions that have been taken or are expected to be taken in tax returns that are not recognized in the financial statements because management has either measured the tax benefit at an amount less than the benefit claimed, or expected to be claimed, or has concluded that it is not more likely than not that the tax position will be ultimately sustained. For the majority of these tax positions, the ultimate deductibility is highly certain, but there is uncertainty about the timing of such deductibility. At December 31, 2013, ACE had no unrecognized tax benefits that, if recognized, would lower the effective tax rate.

Interest and Penalties

ACE recognizes interest and penalties relating to its uncertain tax positions as an element of income tax expense. For the years ended December 31, 2013, 2012 and 2011, ACE recognized $12 million of pre-tax interest income ($7 million after-tax), $2 million of pre-tax interest income ($1 million after-tax), and $5 million of pre-tax interest expense ($3 million after-tax), respectively, as a component of income tax expense. As of December 31, 2013, 2012 and 2011, ACE had accrued interest receivable of $14 million, $7 million and $6 million, respectively, related to effectively settled and uncertain tax positions.

Possible Changes to Unrecognized Tax Benefits

It is reasonably possible that the amount of the unrecognized tax benefit with respect to some of ACE’s uncertain tax positions will significantly increase or decrease within the next 12 months. PHI and its subsidiaries have entered into discussions with the IRS with the intention of seeking a settlement of all tax issues of ACE for open tax years 2001 through 2011. PHI currently believes that it is possible that a settlement with the IRS may be reached in 2014, which could significantly impact the balances of unrecognized tax benefits and the related interest accruals of ACE. At this time, it is estimated that there will be a $4 million to $6 million decrease in unrecognized tax benefits within the next 12 months.

Tax Years Open to Examination

ACE, as an indirect subsidiary of PHI, is included on PHI’s consolidated Federal tax return. ACE’s federal income tax liabilities for all years through 2002 have been determined, subject to adjustment to the extent of any net operating loss or other loss or credit carrybacks from subsequent years. The open tax years for the significant states where ACE files state income tax returns (New Jersey and Pennsylvania) are the same as for the Federal returns. As a result of the final determination of these years, ACE filed amended state returns receiving $1 million in refunds.

Final IRS Regulations on Repair of Tangible Property

In September 2013, the IRS issued final regulations on expense versus capitalization of repairs with respect to tangible personal property. The regulations are effective for tax years beginning on or after January 1, 2014, and provide an option to early adopt the final regulations for tax years beginning on or after January 1, 2012. It is expected that the IRS will issue revenue procedures that will describe how taxpayers may implement the final regulations. The final repair regulations retain the operative rule that the Unit of Property for network assets is determined by the taxpayer’s particular facts and circumstances except as provided in published guidance. In 2012, with the filing of its 2011 tax return, PHI filed a request for an automatic change in accounting method related to repairs of its network assets in accordance with IRS Revenue Procedure 2011-43. ACE does not expect the effects of the final regulations to be significant and will continue to evaluate the impact of the new guidance on its consolidated financial statements.

Other Taxes

Taxes other than income taxes for each year are shown below. These amounts are recoverable through rates.


	2013		2012		2011
	*(millions of dollars)*
Gross Receipts/Delivery	$	10	$	14	$	20
Property		3		3		3
Environmental, Use and Other		1		1		2

Total	$	14	$	18	$	25