(10) INCOME TAXES

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


	Three Months Ended June 30,										Six Months Ended June 30,
	2014					2013					2014					2013
	*(millions of dollars)*
Income tax at federal statutory rate	$	34		35.0	%	$	29		35.0	%	$	77		35.0	%	$	55		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		7		7.1	%		6		7.2	%		15		6.8	%		10		6.4	%
Asset removal costs		(2	)	(2.0	)%		(3	)	(3.6	)%		(5	)	(2.3	)%		(6	)	(3.8	)%
Merger-related costs		7		7.1	%		—		—			7		3.2	%		—		—
Change in estimates and interest related to uncertain and effectively settled tax positions		—		—			3		3.6	%		—		—			54		34.4	%
Establishment of valuation allowances related to deferred tax assets		—		—			—		—			—		—			101		64.3	%
Other, net		(1	)	(1.3	)%		(5	)	(6.1	)%		(3	)	(1.1	)%		1		0.6	%

Consolidated income tax expense related to continuing operations	$	45		45.9	%	$	30		36.1	%	$	91		41.6	%	$	215		136.9	%

In connection with entering into the Merger Agreement (as further described in Note (1), “Organization”), PHI incurred certain merger-related costs in the second quarter of 2014 which are not tax deductible and resulted in a higher effective tax rate in the three and six months ended June 30, 2014.

In the first quarter of 2013, PHI recorded interest expense related to uncertain and effectively settled tax positions of $51 million primarily representing 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 in the first quarter of 2013.

Also, in the first quarter of 2013, PHI established valuation allowances of $101 million related to deferred tax assets. 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 other taxpayers’ cross-border lease and other structured transactions (as discussed in Note (18), “Discontinued Operations – Cross-Border Energy Lease Investments”), (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.

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. In February 2014, the IRS issued revenue procedures that describe how taxpayers should 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.

Income Taxes

(9) INCOME TAXES

A reconciliation of Pepco’s effective income tax rates is as follows:


	Three Months Ended June 30,										Six Months Ended June 30,
	2014					2013					2014					2013
	*(millions of dollars)*
Income tax at federal statutory rate	$	26		35.0	%	$	20		35.0	%	$	43		35.0	%	$	29		35.0	%
Increases (decreases) resulting from:

State income taxes, net of federal effect		4		5.4	%		3		5.3	%		7		5.7	%		5		6.1	%

Asset removal costs		(2	)	(2.7	)%		(3	)	(5.3	)%		(5	)	(4.1	)%		(6	)	(7.3	)%
Change in estimates and interest related to uncertain and effectively settled tax positions		—		—			1		1.8	%		(1	)	(0.8	)%		(4	)	(4.9	)%

Other, net		—		0.1	%		(1	)	(1.7	)%		—		0.3	%		(2	)	(2.1	)%


Income tax expense	$	28		37.8	%	$	20		35.1	%	$	44		36.1	%	$	22		26.8	%

In the first quarter of 2013, Pepco recorded changes in estimates and interest 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 interest benefit in the first quarter of 2013.

Final IRS Regulations on Repair of Tangible Property

In September 2013, the Internal Revenue Service (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. In February 2014, the IRS issued revenue procedures that describe how taxpayers should 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.

Income Taxes

(10) INCOME TAXES

A reconciliation of DPL’s effective income tax rates is as follows:


	Three Months Ended June 30,								Six Months Ended June 30,
	2014				2013				2014					2013
	*(millions of dollars)*
Income tax at federal statutory rate	$	11	35.0	%	$	7	35.0	%	$	33		35.0	%	$	22		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		2	6.3	%		1	4.8	%		5		5.3	%		3		4.8	%
Change in estimates and interest related to uncertain and effectively settled tax positions		—	—			—	—			—		—			(1	)	(1.6	)%
Depreciation		—	—			—	—			(1	)	(1.1	)%		—		—
Other, net		—	(0.7	)%		1	3.1	%		1		1.2	%		1		1.5	%

Income tax expense	$	13	40.6	%	$	9	42.9	%	$	38		40.4	%	$	25		39.7	%

In the first quarter of 2013, DPL recorded changes in estimates and interest 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 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.

Final IRS Regulations on Repair of Tangible Property

In September 2013, the Internal Revenue Service (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. In February 2014, the IRS issued revenue procedures that describe how taxpayers should 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.

Income Taxes

(9) INCOME TAXES

A reconciliation of ACE’s consolidated effective income tax rates is as follows:


	Three Months Ended June 30,									Six Months Ended June 30,
	2014				2013					2014					2013
	*(millions of dollars)*
Income tax at federal statutory rate	$	3	35.0	%	$	4		35.0	%	$	9		35.0	%	$	6		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		1	10.0	%		1		9.1	%		2		7.7	%		1		5.9	%
Change in estimates and interest related to uncertain and effectively settled tax positions		—	—			1		9.1	%		—		—			(9	)	(52.9	)%
Depreciation		—	—			—		—			(1	)	(3.8	)%		—		—
Other, net		—	(5.0	)%		(2	)	(16.8	)%		—		(0.4	)%		3		17.9	%

Consolidated income tax expense	$	4	40.0	%	$	4		36.4	%	$	10		38.5	%	$	1		5.9	%

In the first quarter of 2013, ACE recorded changes in estimates and interest 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.

Final IRS Regulations on Repair of Tangible Property

In September 2013, the Internal Revenue Service (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. In February 2014, the IRS issued revenue procedures that describe how taxpayers should 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.