Income Taxes

12 Months Ended

Dec. 31, 2011

Income Taxes

(12) 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 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 tax liabilities (assets) are shown below.

Provision for Consolidated Income Taxes – Continuing Operations

	For the Year Ended December 31,
	2011			2010			2009
	(millions of dollars)
Current Tax Expense (Benefit)
Federal	$	9		$	(270	)	$	(160	)
State and local		4			(50	)		(32	)
Total Current Tax Expense (Benefit)		13			(320	)		(192	)
Deferred Tax Expense (Benefit)
Federal		121			300			261
State and local		19			34			39
Investment tax credit amortization		(4	)		(3	)		(4	)
Total Deferred Tax Expense		136			331			296
Total Consolidated Income Tax Expense Related to Continuing Operations	$	149		$	11		$	104

Reconciliation of Consolidated Income Tax Expense – Continuing Operations

	For the Year Ended December 31,
	2011					2010					2009
	(millions of dollars)
Income tax at Federal statutory rate	$	143		35.0	%	$	52		35.0	%	$	114		35.0	%
Increases (decreases) resulting from
Depreciation		—		—			(3	)	(2.0	)%		6		1.8	%
State income taxes, net of Federal effect		22		5.4	%		—		—			19		5.7	%
State tax benefits related to prior years' asset dispositions		(4	)	(1.0	)%		—		—			(13	)	(4.0	)%
Cross-border energy lease investments		16		3.9	%		(5	)	(3.3	)%		(6	)	(1.7	)%
Change in estimates and interest related to uncertain and effectively settled tax positions		(11	)	(2.7	)%		(6	)	(4.0	)%		(1	)	(0.4	)%
Investment tax credits		(4	)	(1.0	)%		(4	)	(2.7	)%		(4	)	(1.2	)%
Deferred tax basis adjustments		2		0.2	%		(3	)	(2.0	)%		(4	)	(1.2	)%
Reversal of valuation allowances		—		—			(8	)	(5.3	)%		—		—
Change in state deferred tax balances as a result of restructuring		—		—			(6	)	(4.0	)%		—		—
Other, net		(15	)	(3.4	)%		(6	)	(4.4	)%		(7	)	(2.2	)%
Consolidated Income Tax Expense Related to Continuing Operations	$	149		36.4	%	$	11		7.3	%	$	104		31.8	%

Year ended December 31, 2011

PHI's effective income tax rate in 2011 was significantly affected by changes in estimates and interest 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 (discussed below) 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, PHI recorded an additional tax benefit of $17 million (after-tax) which was recorded in the second quarter of 2011. Further, PHI recalculated 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, which resulted in additional tax expense of $3 million (after-tax).

As discussed further in Note (8), "Leasing Activities," during the second quarter of 2011, PHI terminated early its interest in certain cross-border energy leases prior to the end of their stated terms. As a result of the early terminations, PHI reversed $22 million of previously recognized federal tax benefits associated with those leases which will not be realized.

In addition, as discussed further in Note (17), "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.

Year ended December 31, 2010

In April 2010, as part of an ongoing effort to simplify PHI's organizational structure, certain of PHI's subsidiaries were converted from corporations to single member limited liability companies. In addition to increased organizational flexibility and reduced administrative costs, converting these entities to limited liability companies allows PHI to include income or losses in the former corporations in a single state income tax return, thus increasing the utilization of state income tax attributes. As a result of inclusions of income or losses in a single state return as discussed above, PHI recorded an $8 million benefit by reversing valuation allowances on certain state net operating losses and an additional benefit of $6 million resulting from changes to certain state deferred income tax benefits. In addition, conversion to limited liability companies caused PHI's separate company losses (primarily related to the loss on the extinguishment of debt) to be subjected to state income taxes in new jurisdictions, resulting in minimal consolidated state taxable income in 2010.

In November 2010, PHI reached final settlement with the IRS with respect to its federal tax returns for the years 1996 to 2002 for all issues except its cross-border energy lease investments. In connection with the settlement, PHI reallocated certain amounts on deposit with the IRS since 2006 among liabilities in the settlement years and subsequent years. In light of the settlement and reallocations, PHI recalculated the estimated interest due for the tax years 1996 to 2002. The revised estimate resulted in the reversal of $15 million (after-tax) of estimated interest due to the IRS. This reversal was recorded as an income tax benefit in the fourth quarter of 2010 and PHI recorded an additional tax benefit of $17 million (after-tax) in the second quarter of 2011 when the IRS finalized its calculation of the amount due. Offsetting the 2010 benefit was the reversal of $6 million (after-tax) of erroneously accrued state interest receivable recorded in the first quarter of 2010 and $2 million (after-tax) of other adjustments.

Also in the fourth quarter of 2010, PHI corrected the tax accounting for software amortization. Accordingly, a regulatory asset was established and income tax expense was reduced by $4 million.

Year ended December 31, 2009

During 2009, PHI recorded a decrease to income tax expense of $13 million resulting from the receipt of a refund of $6 million (after-tax) of state income taxes and the establishment of a state tax benefit carryforward of $7 million (after-tax), related to a change in tax reporting for certain asset dispositions occurring in prior years.

During 2009, the IRS issued a Revenue Agent's Report for the audit of PHI's consolidated federal income tax returns for the calendar years 2003 to 2005. The IRS has proposed adjustments to PHI's tax returns, including adjustments to PHI's deductions related to cross-border energy lease investments, the capitalization of overhead costs for tax purposes and the deductibility of certain casualty losses. PHI has appealed certain of the proposed adjustments and believes it has adequately reserved for the adjustments proposed in the Revenue Agents Report. See Note (17), "Commitments and Contingencies – PHI's Cross-Border Energy Lease Investments," for additional information.

During 2009, PHI received a refund of taxes paid in prior years of approximately $138 million, a substantial portion of which is associated with PHI's utility subsidiaries. The refund resulted from the carryback of a 2008 net operating loss for tax reporting purposes that reflected, among other things, significant tax deductions related to accelerated depreciation, the pension plan contributions made in 2009 (which were deductible for 2008) and the cumulative effect of adopting a new method of tax reporting for certain repairs.

Components of Consolidated Deferred Tax Liabilities (Assets)

	At December 31,
	2011			2010
	(millions of dollars)
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	1,871		$	1,680
Deferred electric service and electric restructuring liabilities		131			154
Cross-border energy lease investments		793			816
Federal and state net operating losses		(220	)		(46	)
Valuation allowances on state net operating losses		21			21
Pension and other postretirement benefits		130			70
Deferred taxes on amounts to be collected through future rates		47			43
Other		32			(113	)
Total Deferred Tax Liabilities, net		2,805			2,625
Deferred tax assets included in Current Assets		59			90
Deferred tax liabilities included in Other Current Liabilities		(1	)		(1	)
Total Consolidated Deferred Tax Liabilities, net non-current	$	2,863		$	2,714

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.

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 continues to be amortized to income over the useful lives of the related property.

Reconciliation of Beginning and Ending Balances of Unrecognized Tax Benefits

	2011			2010			2009
	(millions of dollars)
Beginning balance as of January 1,	$	395		$	246		$	255
Tax positions related to current year:
Additions		2			150			(1	)
Reductions		—			—			(2	)
Tax positions related to prior years:
Additions		20			35			77
Reductions		(57	)		(36	)		(83	)
Settlements		(3	)		—			—
Ending balance as of December 31,	$	357		$	395		$	246

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, 2011 included $29 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, 2011, 2010 and 2009, PHI recognized $23 million of pre-tax interest income ($14 million after-tax), $2 million of pre-tax interest income ($1 million after-tax), and $5 million of pre-tax interest income ($3 million after-tax), respectively, as a component of income tax expense related to continuing operations. As of December 31, 2011, 2010 and 2009, PHI had $4 million, $12 million and $13 million, respectively, of accrued interest payable 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 PHI's uncertain tax positions will significantly increase or decrease within the next 12 months. The possible settlement of the cross-border energy lease investments issue, the 2003 to 2005 federal audit, the methodology change for deduction of capitalized construction costs, or state audits could impact the balances and related interest accruals significantly. At this time, an estimate of the range of reasonably possible outcomes cannot be determined.

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.

Resolution of Certain IRS Audit Matters

In 2010, PHI resolved all tax matters that were raised in IRS audits related to the 2001 and 2002 tax years except for the cross-border energy lease issue. Adjustments recorded relating to these resolved tax matters resulted in a $1 million increase to income tax expense exclusive of interest.

Other Taxes

Other taxes for continuing operations are shown below. The annual amounts include $445 million, $427 million and $358 million for the years ended December 31, 2011, 2010 and 2009, respectively, related to Power Delivery, which are recoverable through rates.

	2011		2010		2009
	(millions of dollars)
Gross Receipts/Delivery	$	145	$	145	$	142
Property		71		70		68
County Fuel and Energy		170		154		94
Environmental, Use and Other		65		65		64
Total	$	451	$	434	$	368

Potomac Electric Power Co [Member]

Income Taxes

(11) 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,
	2011			2010			2009
	(millions of dollars)
Current Tax Benefit
Federal	$	(19	)	$	(28	)	$	(33	)
State and local		(16	)		(7	)		(11	)
Total Current Tax Benefit		(35	)		(35	)		(44	)
Deferred Tax Expense (Benefit)
Federal		54			52			95
State and local		19			22			27
Investment tax credit amortization		(2	)		(2	)		(2	)
Total Deferred Tax Expense		71			72			120
Total Income Tax Expense	$	36		$	37		$	76

Reconciliation of Income Tax Expense

	For the Year Ended December 31,
	2011					2010					2009
	(millions of dollars)
Income tax at Federal statutory rate	$	47		35.0	%	$	51		35.0	%	$	64		35.0	%
Increases (decreases) resulting from
Depreciation		(1	)	(0.7	)%		3		2.1	%		5		2.9	%
Asset removal costs		(7	)	(5.0	)%		(3	)	(2.1	)%		(3	)	(1.6	)%
State income taxes, net of federal effect		8		5.5	%		8		5.5	%		10		5.5	%
Software amortization		—		(0.3	)%		(4	)	(2.8	)%		2		1.1	%
Investment tax credits		(2	)	(1.1	)%		(2	)	(1.4	)%		(2	)	(1.1	)%
Change in estimates and interest related to uncertain and effectively settled tax positions		(9	)	(6.6	)%		(11	)	(7.6	)%		4		2.2	%
Other, net		—		(0.1	)%		(5	)	(3.2	)%		(4	)	(2.2	)%
Income Tax Expense	$	36		26.7	%	$	37		25.5	%	$	76		41.8	%

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, 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.

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). Further during the third quarter of 2010, Pepco reversed $2 million of previously recorded tax benefits related to changes in estimates and interest related to uncertain and effectively settled tax positions.

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.

Year ended December 31, 2010

In November 2010, PHI reached final settlement with the IRS with respect to its Federal tax returns for the years 1996 to 2002. In connection with the settlement, Pepco reallocated certain amounts on deposit with the IRS since 2006 among liabilities in the settlement years and subsequent years. In light of the settlement and reallocation, Pepco recalculated the estimated interest due for the tax years 1996 to 2002. The revised estimate resulted in the reversal of $24 million (after-tax) of previously accrued estimated interest due to the IRS. This reversal has been recorded as an income tax benefit in the fourth quarter of 2010.

This benefit was partially offset by the reversal of $8 million of previously recorded tax benefits and $5 million of other adjustments.

Also in the fourth quarter of 2010, Pepco corrected the tax accounting for software amortization. Accordingly, a regulatory asset was established and income tax expense was reduced by $4 million.

Year ended December 31, 2009

In March 2009, the IRS issued a Revenue Agent's Report for the audit of PHI's consolidated Federal income tax returns for the calendar years 2003 to 2005. The IRS has proposed adjustments to PHI's tax returns, including adjustments to Pepco's capitalization of overhead costs for tax purposes and the deductibility of certain Pepco casualty losses. In conjunction with PHI, Pepco has appealed certain of the proposed adjustments and believes it has adequately reserved for the adjustments included in the Revenue Agent's Report.

In November 2009, Pepco received a refund of prior years' Federal income taxes of $51 million. The refund results from the carryback of PHI's 2008 net operating loss for tax reporting purposes that reflected, among other things, significant tax deductions related to accelerated depreciation, the pension plan contributions paid in 2009 (which were deducted in 2008) and the cumulative effect of adopting a new method of tax reporting for certain repairs.

During 2009, a reconciliation of current and deferred income tax accounts was completed and, as a result, a $1 million net credit was booked to income tax expense. The 2009 adjustment is primarily included in "Other" in the reconciliation above.

Components of Deferred Income Tax Liabilities (Assets)

	At December 31,
	2011			2010
	(millions of dollars)
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	902		$	803
Pension and other postretirement benefits		117			100
Deferred taxes on amounts to be collected through future rates		20			15
Federal and state net operating losses		(80	)		—
Other		69			27
Total Deferred Tax Liabilities, net		1,028			945
Deferred tax assets included in Other Current Assets		11			13
Total Deferred Tax Liabilities, net non-current	$	1,039		$	958

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, 2011 and 2010.

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 continues to be amortized to income over the useful lives of the related property.

Reconciliation of Beginning and Ending Balances of Unrecognized Tax Benefits

	2011			2010			2009
	(millions of dollars)
Beginning balance as of January 1,	$	190		$	71		$	62
Tax positions related to current year:
Additions		—			110			—
Reductions		—			—			(2	)
Tax positions related to prior years:
Additions		12			24			45
Reductions		(26	)		(15	)		(34	)
Settlements		(3	)		—			—
Ending balance as of December 31,	$	173		$	190		$	71

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, 2011, Pepco had $8 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, 2011, 2010 and 2009, Pepco recognized $8 million of pre-tax interest income ($5 million after-tax), $27 million of pre-tax interest income ($16 million after-tax), and $7 million of pre-tax interest expense ($4 million after-tax), respectively, as a component of income tax expense. As of December 31, 2011, 2010 and 2009, Pepco had accrued interest payable of $6 million, accrued interest receivable of $8 million and accrued interest payable of $8 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. The final settlement of the 2003 to 2005 federal audit, the methodology change for deduction of capitalized construction costs, or state audits could impact the balances and related interest accruals significantly. At this time, an estimate of the range of reasonably possible outcomes cannot be determined.

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 has 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.

Other Taxes

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

	2011		2010		2009
	(millions of dollars)
Gross Receipts/Delivery	$	109	$	108	$	104
Property		44		42		41
County Fuel and Energy		170		154		94
Environmental, Use and Other		59		60		63
Total	$	382	$	364	$	302

Delmarva Power & Light Co/De [Member]

Income Taxes

(12) 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,
	2011			2010			2009
	(millions of dollars)
Current Tax (Benefit) Expense
Federal	$	(22	)	$	(37	)	$	(26	)
State and local		8			(5	)		(17	)
Total Current Tax Benefit		(14	)		(42	)		(43	)
Deferred Tax Expense (Benefit)
Federal		53			61			58
State and local		4			13			2
Investment tax credit amortization		(1	)		(1	)		(1	)
Total Deferred Tax Expense		56			73			59
Total Income Tax Expense	$	42		$	31		$	16

Reconciliation of Income Tax Expense

	For the Year Ended December 31,
	2011					2010					2009
	(millions of dollars)
Income tax at Federal statutory rate	$	40		35.0	%	$	27		35.0	%	$	24		35.0	%
Increases (decreases) resulting from Depreciation		1		0.9	%		1		1.3	%		2		2.9	%
State income taxes, net of Federal effect		6		5.3	%		4		5.3	%		4		5.9	%
State tax benefit related to prior years' asset dispositions		—		—			—		—			(13	)	(19.1	)%
Investment tax credits		(1	)	(0.9	)%		(1	)	(1.3	)%		(1	)	(1.5	)%
Change in estimates and interest related to uncertain and effectively settled tax positions		(3	)	(2.7	)%		1		1.3	%		(1	)	(1.5	)%
Adjustments to prior years' taxes		—		—			—		—			2		2.9	%
Deferred tax basis adjustments		(1	)	(0.9	)%		—		—			—		—
Other, net		—		0.5	%		(1	)	(0.8	)%		(1	)	(1.1	)%
Income Tax Expense	$	42		37.2	%	$	31		40.8	%	$	16		23.5	%

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 an additional $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. This resulted in an additional tax expense of $1 million (after-tax).

Year ended December 31, 2010

In November 2010, PHI reached final settlement with the IRS with respect to its Federal tax returns for the years 1996 to 2002. In connection with the settlement, PHI reallocated certain amounts on deposit with the IRS since 2006 among liabilities in the settlement years and subsequent years. In light of the settlement and reallocations, DPL recalculated the estimated interest due for the tax years 1996 to 2002. The revised estimate resulted in an additional $3 million (after-tax) of estimated interest due to the IRS. This additional estimated interest expense was recorded in the fourth quarter of 2010. This expense is partially offset by the reversal of $2 million of previously recorded tax liabilities.

Year ended December 31, 2009

During 2009, DPL recorded a decrease to tax expense of $13 million resulting from the receipt of a refund of $6 million (after-tax) of state income taxes and the establishment of a state income tax benefit carry forward of $7 million (after-tax), related to a change in tax reporting for certain asset dispositions occurring in prior years.

In March 2009, the IRS issued a Revenue Agent's Report for the audit of PHI's consolidated Federal income tax returns for the calendar years 2003 to 2005. The IRS has proposed adjustments to PHI's tax returns, including adjustments to DPL's capitalization of overhead costs for tax purposes and the deductibility of certain DPL casualty losses. In conjunction with PHI, DPL has appealed certain of the proposed adjustments and believes it has adequately reserved for the adjustments included in the Revenue Agent's Report.

In November 2009, DPL received a refund of prior years' Federal income taxes of $10 million. The refund results from the carryback of a 2008 net operating loss for tax reporting purposes that reflected, among other things, significant tax deductions related to accelerated depreciation, the pension plan contributions paid in 2009 (which were deducted in 2008) and the cumulative effect of adopting a new method of tax reporting for certain repairs.

Components of Deferred Income Tax Liabilities (Assets)

	As of December 31,
	2011			2010
	(millions of dollars)
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	526		$	475
Deferred taxes on amounts to be collected through future rates		14			14
State net operating losses		(57	)		(9	)
Pension and other postretirement benefits		86			53
Other		34			16
Total Deferred Tax Liabilities, net		603			549
Deferred tax assets included in Other Current Assets		11			13
Deferred tax liabilities included in Other Current Liabilities		1			(1	)
Total Deferred Tax Liabilities, net non-current	$	615		$	561

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, 2011 and 2010.

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 continues to be amortized to income over the useful lives of the related property.

Reconciliation of Beginning and Ending Balances of Unrecognized Tax Benefits

	2011			2010			2009
	(millions of dollars)
Beginning balance as of January 1,	$	40		$	39		$	54
Tax positions related to current year:
Additions		—			3			—
Tax positions related to prior years:
Additions		7			5			10
Reductions		(12	)		(7	)		(25	)
Settlements		—			—			—
Ending balance as of December 31,	$	35		$	40		$	39

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, 2011, DPL had no 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, 2011, 2010 and 2009, DPL recognized $6 million of pre-tax interest income ($4 million after-tax), $6 million of pre-tax interest expense ($4 million after-tax), and $3 million of pre-tax interest income ($2 million after-tax), respectively, as a component of income tax expense. As of December 31, 2011, 2010 and 2009, DPL had accrued interest receivable of $1 million and accrued interest payable of $5 million and $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. The final settlement of the 2003 to 2005 Federal audit, the methodology change for deduction of capitalized construction costs, or state audits could impact the balances and related interest accruals significantly. At this time, an estimate of the range of reasonably possible outcomes cannot be determined.

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.

Other Taxes

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

	2011		2010		2009
	(millions of dollars)
Gross Receipts/Delivery	$	15	$	16	$	17
Property		19		19		18
Environmental, Use and Other		3		2		—
Total	$	37	$	37	$	35

Atlantic City Electric Co [Member]

Income Taxes

(11) 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,
	2011			2010			2009
	(millions of dollars)
Current Tax (Benefit) Expense
Federal	$	(9	)	$	(5	)	$	(32	)
State and local		1			—			(3	)
Total Current Tax Benefit		(8	)		(5	)		(35	)
Deferred Tax Expense (Benefit)
Federal		35			33			42
State and local		7			16			11
Investment tax credit amortization		(1	)		(1	)		(1	)
Total Deferred Tax Expense		41			48			52
Total Consolidated Income Tax Expense	$	33		$	43		$	17

Reconciliation of Consolidated Income Tax Expense

	For the Year Ended December 31,
	2011					2010					2009
	(millions of dollars)
Income tax at Federal statutory rate	$	25		35.0	%	$	33		35.0	%	$	20		35.0	%
Increases (decreases) resulting from State income taxes, net of Federal effect		4		6.0	%		7		7.3	%		5		8.6	%
Investment tax credits		(1	)	(1.3	)%		(1	)	(1.0	)%		(1	)	(1.7	)%
Change in estimates and interest related to uncertain and effectively settled tax positions		5		6.9	%		5		5.2	%		(5	)	(8.6	)%
Adjustments to prior years' taxes		(1	)	(1.7	)%		—		—			(1	)	(1.7	)%
Other, net		1		0.9	%		(1	)	(1.7	)%		(1	)	(2.3	)%
Consolidated Income Tax Expense	$	33		45.8	%	$	43		44.8	%	$	17		29.3	%

Year ended December 31, 2011

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 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 IRS in 2006. This resulted in an additional tax expense of $3 million (after-tax).

Year ended December 31, 2010

In November 2010, PHI reached final settlement with the IRS with respect to its federal tax returns for the years 1996 to 2002. In connection with the settlement, PHI reallocated certain amounts on deposit with the IRS since 2006 among liabilities in the settlement years and subsequent years. In light of the

settlement and reallocations, ACE recalculated the estimated interest due for the tax years 1996 to 2002. The revised estimate resulted in an additional $1 million (after-tax) of estimated interest due to the IRS for the tax years 1996 to 2002. This additional interest expense was recorded in the fourth quarter of 2010. In addition to this adjustment, in 2010 ACE reversed $6 million of accrued interest income on uncertain and effectively settled state income tax positions, as discussed in Note (2), "Significant Accounting Policies." This is partially offset by $1 million of other adjustments.

Year ended December 31, 2009

In March 2009, the IRS issued a Revenue Agent's Report for the audit of PHI's consolidated Federal income tax returns for the calendar years 2003 to 2005. The IRS has proposed adjustments to PHI's tax returns, including adjustments to ACE's capitalization of overhead costs for tax purposes and the deductibility of certain ACE casualty losses. In conjunction with PHI, ACE has appealed certain of the proposed adjustments, and believes it has adequately reserved for the adjustments proposed in the Revenue Agent's Report.

In November 2009, ACE received a refund of prior years' Federal income taxes of $9 million. The refund results from the carryback of PHI's 2008 net operating loss for tax reporting purposes that reflected, among other things, significant tax deductions related to accelerated depreciation, the pension plan contributions paid in 2009 (which were deducted in 2008) and the cumulative effect of adopting a new method of tax reporting for certain repairs.

Components of Consolidated Deferred Income Tax Liabilities (Assets)

	As of December 31,
	2011		2010
	(millions of dollars)
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	424	$	389
Deferred taxes on amounts to be collected through future rates		11		14
Payment for termination of purchased power contracts with NUGs		53		59
Electric restructuring liabilities		137		160
Fuel and purchased energy		4		7
Other		60		20
Total Deferred Tax Liabilities, net		689		649
Deferred tax assets included in Other Current Assets		9		10
Total Consolidated Deferred Tax Liabilities, net non-current	$	698	$	659

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, 2011 and 2010.

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 continues to be amortized to income over the useful lives of the related property.

Reconciliation of Beginning and Ending Balances of Unrecognized Tax Benefits

	2011			2010			2009
	(millions of dollars)
Beginning balance as of January 1,	$	83		$	39		$	49
Tax positions related to current year:
Additions		2			50			1
Reductions		—			(1	)		—
Tax positions related to prior years:
Additions		4			—			10
Reductions		(10	)		(5	)		(21	)
Settlements		—			—			—
Ending balance as of December 31,	$	79		$	83		$	39

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, 2011, ACE had $5 million of 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, 2011, 2010 and 2009, ACE recognized $5 million of pre-tax interest expense ($3 million after-tax), $8 million of pre-tax interest expense ($5 million after-tax), and $9 million of pre-tax interest income ($6 million after-tax), respectively, as a component of income tax expense. As of December 31, 2011, 2010 and 2009, ACE had $6 million, $14 million and $19 million, respectively, of accrued interest receivable 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. The final settlement of the 2003 to 2005 federal audit, the methodology change for deduction of capitalized construction costs, or state audits could impact the balances and related interest accruals significantly. At this time, an estimate of the range of reasonably possible outcomes cannot be determined.

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 has filed amended state returns requesting $1 million in refunds which are subject to review by the various states.

Other Taxes

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

	2011		2010		2009
	(millions of dollars)
Gross Receipts/Delivery	$	20	$	20	$	20
Property		3		3		2
Environmental, Use and Other		2		3		(1	)
Total	$	25	$	26	$	21