Income Taxes

9 Months Ended

Sep. 30, 2011

Income Taxes

(10) INCOME TAXES

A reconciliation of PHI's consolidated effective income tax rate from continuing operations is as follows:

	Three Months Ended September 30,										Nine Months Ended September 30,
	2011					2010					2011					2010
	(millions of dollars)
Income tax at federal statutory rate	$	47		35.0	%	$	5		35.0	%	$	133		35.0	%	$	62		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		9		6.7			(6	)	(37.3	)		19		5.0			4		2.0
Depreciation		(1	)	(0.7	)		2		9.3			(2	)	(0.5	)		4		2.4
Cross-border energy lease investments		(5	)	(3.7	)		(2	)	(10.0	)		15		3.9			(4	)	(2.3	)
Change in estimates and interest related to uncertain and effectively settled tax positions		5		3.7			—		(0.7	)		(11	)	(2.9	)		10		5.5
Tax credits		(1	)	(0.7	)		(1	)	(6.0	)		(3	)	(0.8	)		(3	)	(1.6	)
Dividends on PHI shares held in retirement savings plan		(1	)	(0.7	)		—		(3.3	)		(2	)	(0.5	)		(2	)	(0.9	)
Release of deferred tax asset valuation allowance		—		—			—		—			—		—			(8	)	(4.4	)
Change in state deferred tax balances as a result of corporate restructuring		—		—			2		14.0			—		—			(6	)	(3.6	)
Asset removal costs		(2	)	(1.5	)		(1	)	(4.7	)		(4	)	(1.1	)		(2	)	(1.0	)
Adjustment to prior year taxes		—		—			—		(3.3	)		—		—			(1	)	(0.4	)
Deferred tax basis adjustments		—		—			(4	)	(28.7	)		1		0.3			—		(0.2	)
Other, net		4		2.6			(1	)	(4.3	)		(3	)	(0.8	)		(2	)	(1.1	)
Consolidated income tax expense related to continuing operations	$	55		40.7	%	$	(6	)	(40.0	)%	$	143		37.6	%	$	52		29.4	%

Three Months Ended September 30, 2011 and 2010

PHI's consolidated effective tax rates from continuing operations for the three months ended September 30, 2011 and 2010 were 40.7% and (40.0)%, respectively. The increase in the effective tax rate was primarily due to the non-recurring benefit recorded in the third quarter of 2010 related to the 2010 corporate restructuring that impacted state tax expense and state deferred tax balances, the benefit of certain deferred tax basis adjustments recorded in 2010 and changes in estimates and interest related to uncertain and effectively settled tax positions.

In addition, as discussed further in Note (15) "Commitments and Contingencies—District of Columbia Tax Legislation," the Fiscal Year 2012 Budget Support Act of 2011 (the Budget Support Act) became law during the third quarter of 2011. The Budget Support Act includes a provision that requires corporate taxpayers in the District of Columbia (the District) 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 was taxed. As a result of the change, during the third quarter of 2011, PHI recorded an additional state income tax expense of $2 million.

The deferred tax basis adjustments recorded in 2010 were the result of a $2 million adjustment to eliminate deferred tax liabilities associated with a goodwill impairment charge recorded in 2005, and the recording of a $2 million benefit related to deferred tax attributes.

Nine Months Ended September 30, 2011 and 2010

PHI's consolidated effective tax rates from continuing operations for the nine months ended September 30, 2011 and 2010 were 37.6% and 29.4%, respectively. The increase in the effective tax rate was primarily due to the impact of the early termination of certain cross border energy leases and the non-recurring benefit recorded in the third quarter of 2010 related to the 2010 corporate restructuring that impacted state tax expense and state deferred tax balances. This increase was partially offset by interest benefits associated with the settlement with the Internal Revenue Service (IRS) discussed below (included in changes in estimates and interest related to uncertain and effectively settled tax positions).

As discussed further in Note (7), "Leasing Activities," during the second quarter of 2011, PHI terminated early its interest in certain cross-border energy leases prior to the end of the stated term. As a result of the early terminations, PHI reversed $22 million of previously recognized Federal income tax benefits associated with those leases which will not be realized.

In the second quarter of 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 had been on deposit with the IRS since 2006 among liabilities in the settlement years and subsequent years. Primarily related to the settlement and reallocations, PHI has recorded an additional tax benefit in the amount of $17 million (after-tax). This additional interest income was recorded in the second quarter of 2011.

As discussed above, PHI also recorded additional state tax expense as a result of the District's mandatory unitary combined reporting in the third quarter of 2011.

The 2010 effective tax rate also included the non-recurring impact of the April 2010 corporate restructuring. As a result of this restructuring, PHI recorded approximately $16 million of non-recurring tax benefits in 2010 including approximately $8 million resulting from a change in state apportionment factors and the release of $8 million of valuation allowances on deferred tax assets related to state net operating losses.

Also included in changes in estimates and interest related to uncertain and effectively settled tax positions for 2010 is $6 million of additional income tax expense related to erroneously recorded interest income for state tax purposes on uncertain and effectively settled tax positions as further discussed in Note (2), "Significant Accounting Policies—Income Tax Adjustments."

Potomac Electric Power Co [Member]

Income Taxes

(8) INCOME TAXES

A reconciliation of Pepco's effective income tax rate is as follows:

	Three Months Ended September 30,											Nine Months Ended September 30,
	2011					2010						2011					2010
	(millions of dollars)
Income tax at federal statutory rate	$	21		35.0	%		$	25		35.0	%	$	42		35.0	%		$	49		35.0	%
Increases (decreases) resulting from:
Depreciation		—		—				1		1.7			—		—				4		2.7
Change in estimates and interest related to uncertain and effectively settled tax positions		1		1.3				5		6.8			(4	)	(2.7	)			7		5.1
State income taxes, net of federal effect		4		6.1				4		5.4			6		5.3				8		5.5
Permanent differences related to deferred compensation funding		—		(0.3	)			—		(0.4	)		(2	)	(1.4	)			(1	)	(0.6	)
State tax benefit related to prior years' asset dispositions		—		—				—		—			(4	)	(3.5	)			—		—
Asset removal costs		(2	)	(3.0	)			(1	)	(1.0	)		(4	)	(3.7	)			(2	)	(1.3	)
Other, net		(1	)	(1.4	)			(1	)	(0.4	)		(2	)	(2.3	)			(3	)	(1.8	)
Income tax expense	$	23		37.7	%		$	33		47.1	%	$	32		26.7	%		$	62		44.6	%

PEPCO

Three Months Ended September 30, 2011 and 2010

Pepco's effective tax rates for the three months ended September 30, 2011 and 2010 were 37.7% and 47.1%, respectively. The decrease in the effective tax rate primarily resulted from changes in estimates and interest related to uncertain and effectively settled tax positions and an increase in certain asset removal costs.

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 Internal Revenue Service in 2006. This resulted in an additional tax expense of $1 million (after-tax). Further during the third quarter of 2010, Pepco reversed $2 million of previously recorded tax benefits related to changes in estimates and interests related to uncertain and effectively settle tax positions.

Nine Months Ended September 30, 2011 and 2010

Pepco's effective tax rates for the nine months ended September 30, 2011 and 2010 were 26.7% and 44.6%, respectively. The decrease in the effective tax rate primarily resulted from changes in estimates and interest related to uncertain and effectively settled tax positions, and a state tax benefit recorded in 2011 related to prior year's asset dispositions.

During the second quarter of 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, Pepco has recorded an additional tax benefit in the amount of $5 million (after-tax). This additional interest income was recorded in the second quarter of 2011. This was partially offset by the recalculation of interest on Pepco's uncertain tax positions for open tax years discussed above.

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 as a result of an increase in tax basis on certain prior years' asset dispositions.

Delmarva Power & Light Co/De [Member]

Income Taxes

(9) INCOME TAXES

A reconciliation of DPL's effective income tax rate is as follows:

	Three Months Ended September 30,									Nine Months Ended September 30,
	2011					2010				2011					2010
	(millions of dollars)
Income tax at federal statutory rate	$	7		35.0	%	$	6	35.0	%	$	31		35.0	%	$	18		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		1		5.2			1	5.0			5		5.3			3		5.2
Depreciation		—		(0.5	)		—	3.8			—		—			2		2.7
Tax credits		—		(1.0	)		—	(1.3	)		(1	)	(0.6	)		(1	)	(1.2	)
Change in estimates and interest related to uncertain and effectively settled tax positions		2		9.5			—	(0.6	)		(3	)	(3.1	)		1		2.1
Adjustments to prior year taxes		(1	)	(4.8	)		—	1.9			(1	)	(1.1	)		—		0.6
Other, net		1		4.2			—	—			1		0.9			—		(0.2	)
Income tax expense	$	10		47.6	%	$	7	43.8	%	$	32		36.4	%	$	23		44.2	%

Three Months Ended September 30, 2011 and 2010

DPL's effective tax rates for the three months ended September 30, 2011 and 2010 were 47.6% and 43.8%, respectively. The increase in the effective tax rate primarily resulted from changes in estimates and interest related to uncertain and effectively settled tax positions as well as adjustments to prior year taxes.

During the third quarter of 2011, DPL reached agreement with state taxing authorities related to certain state tax liabilities resulting in an increase to tax expense of $1 million (after-tax). Further, in the third quarter DPL recalculated interest on its uncertain tax positions for open tax years using different assumptions related to the application of its deposit made with the Internal Revenue Service in 2006. This resulted in an additional tax expense of $1 million (after-tax). Also during the third quarter DPL recorded a reduction to tax expense of $1 million (after-tax) related to certain non-recurring adjustments to prior year taxes.

Nine Months Ended September 30, 2011 and 2010

DPL's effective tax rates for the nine months ended September 30, 2011 and 2010 were 36.4% and 44.2%, respectively. The decrease in the effective tax rate resulted from changes in estimates and interest related to uncertain and effectively settled tax positions, primarily related to the $2 million reversal of accrued interest income on state income tax positions recorded in 2010 that DPL no longer believes is more likely than not to be realized, and an additional $2 million interest benefit from the reallocation of deposits discussed below.

During the second quarter of 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 additional interest income of $4 million (after-tax) in the second quarter of 2011. This benefit is partially offset by the 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 tax expense of $1 million associated with the recalculation of interest on uncertain tax positions for open tax years using different assumptions related to the application of its deposit made with the Internal Revenue Service in 2006.

Atlantic City Electric Co [Member]

Income Taxes

(8) INCOME TAXES

A reconciliation of ACE's consolidated effective income tax rate is as follows:

	Three Months Ended September 30,										Nine Months Ended September 30,
	2011					2010					2011					2010
Income tax at federal statutory rate	$	12		35.0	%	$	18		35.0	%	$	27		35.0	%	$	34		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		2		4.4			3		6.6			5		5.9			7		6.8
Change in estimates and interest related to uncertain and effectively settled tax positions		4		10.5			(1	)	(1.2	)		4		5.1			4		3.7
Deferred tax adjustment		—		—			—		—			1		1.7			—		—
Other, net		(1	)	0.1			—		(0.4	)		(1	)	(0.9	)		(2	)	(1.2	)
Consolidated income tax expense	$	17		50.0	%	$	20		40.0	%	$	36		46.8	%	$	43		44.3	%

Three Months Ended September 30, 2011 and 2010

ACE's consolidated effective tax rates for the three months ended September 30, 2011 and 2010 were 50.0% and 40.0%, respectively. The increase in the effective tax rate primarily resulted from changes in estimates and interest related to uncertain and effectively settled tax positions.

During the third quarter of 2011 the company recalculated interest on its uncertain tax positions for open tax years using different assumptions related to the application of its deposit made with the Internal Revenue Service in 2006. This resulted in an additional tax expense of $3 million (after-tax).

Nine Months Ended September 30, 2011 and 2010

ACE's consolidated effective tax rates for the nine months ended September 30, 2011 and 2010 were 46.8% and 44.3%, respectively. The increase in the effective tax rate primarily resulted from ACE's reconciliation of deferred taxes on certain regulatory assets which resulted in a $1 million increase to income tax expense included in the deferred tax adjustment and changes in estimates and interest related to uncertain and effectively settled tax positions.

During the second quarter of 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, ACE has recorded an additional $1 million (after-tax) of interest due to the IRS. This additional interest expense was recorded in the second quarter of 2011. This is further impacted by the adjustment recorded in the third quarter of 2011 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 Internal Revenue Service in 2006.

Also, during the first quarter of 2010, ACE recorded an adjustment to correct certain income tax errors related to prior periods. The adjustment resulted in an increase in income tax expense of $6 million for the nine months ended September 30, 2010. The adjustment represents the reversal of erroneously recorded interest income for state income tax purposes related to uncertain and effectively settled tax positions, including $2 million, $3 million and $1 million recorded in 2009, 2008 and 2007, respectively.