(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,
	2014			2013			2012
	*(millions of dollars)*
Current Tax (Benefit) Expense
Federal	$	(137	)	$	(128	)	$	(166	)
State and local		(26	)		(9	)		(40	)

Total Current Tax (Benefit) Expense		(163	)		(137	)		(206	)

Deferred Tax Expense (Benefit)
Federal		261			393			254
State and local		41			65			58
Investment tax credit amortization		(1	)		(2	)		(3	)

Total Deferred Tax Expense		301			456			309

Total Consolidated Income Tax Expense Related to Continuing Operations	$	138		$	319		$	103

Reconciliation of Consolidated Income Tax Expense – Continuing Operations


	For the Year Ended December 31,
	2014					2013					2012
	*(millions of dollars)*
Income tax at Federal statutory rate	$	133		35.0	%	$	150		35.0	%	$	112		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		23		6.1	%		27		6.3	%		19		6.0	%
Asset removal costs		(12	)	(3.2	)%		(14	)	(3.3	)%		(11	)	(3.4	)%
Change in estimates and interest related to uncertain and effectively settled tax positions		—		—			56		13.1	%		(8	)	(2.6	)%
Establishment of valuation allowances related to deferred tax assets		—		—			101		23.5	%		—		—
Merger related costs		7		1.8	%		—		—			—		—
Other, net		(13	)	(3.4	)%		(1	)	(0.2	)%		(9	)	(2.9	)%

Consolidated Income Tax Expense Related to Continuing Operations	$	138		36.3	%	$	319		74.4	%	$	103		32.1	%

During 2014, PHI recorded a tax benefit of $5 million related to certain energy efficiency tax deductions associated with Pepco Energy Services’ energy savings performance contracting services.

In connection with entering into the Merger Agreement (as further described in Note (1), “Organization”), PHI incurred certain merger-related costs in 2014 which are not tax deductible.

During 2013, PHI recorded a $56 million charge for a change in estimates and interest related to uncertain and effectively settled tax positions, 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 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 (20), “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.

PHI’s consolidated effective income tax rate for the year ended December 31, 2012 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.

Components of Consolidated Deferred Tax Liabilities (Assets)


	At December 31,
	2014			2013
	*(millions of dollars)*
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	2,962		$	2,628
Deferred electric service and electric restructuring liabilities		67			91
Cross-border energy lease investments		—			(6	)
Federal and state net operating losses		(400	)		(350	)
Valuation allowances on state net operating losses		61			21
Pension and other postretirement benefits		116			135
Deferred taxes on amounts to be collected through future rates		94			75
Other (a)		325			285

Total Deferred Tax Liabilities, net		3,225			2,879
Deferred tax assets included in Current Assets		50			51
Deferred tax liabilities included in Other Current Liabilities		(9	)		(2	)

Total Consolidated Deferred Tax Liabilities, net non-current	$	3,266		$	2,928

(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.

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 2034.

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


	2014			2013			2012
	*(millions of dollars)*
Balance as of January 1,	$	831		$	200		$	357
Tax positions related to current year:
Additions		4			3			1
Reductions		(2	)		—			—
Tax positions related to prior years:
Additions		27			646	(a)		79
Reductions		(10	)		(12	)		(235	)(b)
Settlements		—			(6	)		(2	)

Balance as of December 31,	$	850		$	831		$	200

(a)	These additions of unrecognized tax benefits in 2013 primarily relate to the former 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, 2014 included $12 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, 2014, 2013 and 2012, PHI recognized less than $1 million of pre-tax interest expense, $125 million of pre-tax interest expense ($75 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, 2014, 2013 and 2012, PHI had accrued interest receivable of $2 million, $2 million and $10 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 2015, 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 (16), “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 August 2011, the IRS issued Revenue Procedure 2011-43 providing a safe harbor method of tax accounting for repair costs associated with electric transmission and distribution property. In September 2012, with the filing of its 2011 tax return, PHI adopted the safe harbor for the 2011 tax year. In September 2013, the IRS published final regulations regarding the tax treatment of costs incurred to acquire, produce or improve tangible property. In February 2014, the IRS issued revenue procedures that describe how taxpayers should implement the final regulations. The final repair regulations and the related revenue procedures did not modify the guidance set forth in Revenue Procedure 2011-43 that the Unit of Property for electric transmission and distribution network assets is determined by the taxpayer’s particular facts and circumstances. The final regulations did not have a material impact on PHI’s consolidated financial statements.

Other Taxes

Other taxes for continuing operations are shown below. The annual amounts include $407 million, $422 million and $426 million for the years ended December 31, 2014, 2013 and 2012, respectively, related to Power Delivery, which are recoverable through rates.


	2014		2013		2012
	*(millions of dollars)*
Gross Receipts/Delivery	$	123	$	133	$	135
Property		84		77		75
County Fuel and Energy		143		153		160
Environmental, Use and Other		63		65		62

Total	$	413	$	428	$	432

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,
	2014			2013			2012
	*(millions of dollars)*
Current Tax (Benefit) Expense
Federal	$	(45	)	$	(8	)	$	(9	)
State and local		—			—			(1	)

Total Current Tax Benefit		(45	)		(8	)		(10	)

Deferred Tax Expense (Benefit)
Federal		99			53			44
State and local		12			12			11
Investment tax credit amortization		(1	)		(1	)		(1	)

Total Deferred Tax Expense		110			64			54

Total Income Tax Expense	$	65		$	56		$	44

Reconciliation of Income Tax Expense


	For the Year Ended December 31,
	2014					2013					2012
	*(millions of dollars)*
Income tax at Federal statutory rate	$	59		35.0	%	$	51		35.0	%	$	41		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		9		5.3	%		8		5.5	%		6		5.1	%
Other, net		(3	)	(1.8	)%		(3	)	(1.9	)%		(3	)	(2.5	)%

Income Tax Expense	$	65		38.5	%	$	56		38.6	%	$	44		37.6	%

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 (after-tax) interest benefit in the first quarter of 2013, which is included above in Other, net.

Components of Deferred Income Tax Liabilities (Assets)


	As of December 31,
	2014			2013
	*(millions of dollars)*
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	797		$	712
Deferred taxes on amounts to be collected through future rates		19			16
Federal and state net operating losses		(115	)		(125	)
Pension and other postretirement benefits		80			80
Electric restructuring liabilities		(4	)		(5	)
Other		101			80

Total Deferred Tax Liabilities, net		878			758
Deferred tax assets included in Current Assets		16			59
Deferred tax liabilities included in Other Current Liabilities		(1	)		(1	)

Total Deferred Tax Liabilities, net non-current	$	893		$	816

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, 2014 and 2013. Federal and state net operating losses generally expire over 20 years from 2029 to 2034.

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


	2014			2013		2012
	*(millions of dollars)*
Balance as of January 1	$	9		$	9	$	35
Tax positions related to current year:
Additions		1			—		—
Reductions		—			—		—
Tax positions related to prior years:
Additions		13			—		—
Reductions		(1	)		—		(26	)(a)
Settlements		—			—		—

Balance as of December 31	$	22		$	9	$	9

(a)	These reductions of unrecognized tax benefits in 2012 primarily relate to a resolution reached with the Internal Revenue Service (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, 2014, 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 each of the years ended December 31, 2014, 2013 and 2012, DPL recognized less than $1 million of pre-tax interest income as a component of income tax expense. As of December 31, 2014, 2013 and 2012, DPL had accrued interest receivable of $2 million, $2 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. 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 2015, 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 $14 million to $18 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 August 2011, the IRS issued Revenue Procedure 2011-43 providing a safe harbor method of tax accounting for repair costs associated with electric transmission and distribution property. In September 2012, with the filing of its 2011 tax return, PHI adopted the safe harbor for the 2011 tax year. In September 2013, the IRS published final regulations regarding the tax treatment of costs incurred to acquire, produce or improve tangible property. In February 2014, the IRS issued revenue procedures that describe how taxpayers should implement the final regulations. The final repair regulations and the related revenue procedures did not modify the guidance set forth in Revenue Procedure 2011-43 that the Unit of Property for electric transmission and distribution network assets is determined by the taxpayer’s particular facts and circumstances. The final regulations did not have a material impact on DPL’s financial statements.

Other Taxes

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


	2014		2013		2012
	*(millions of dollars)*
Gross Receipts/Delivery	$	16	$	15	$	14
Property		24		24		21
Environmental, Use and Other		2		1		1

Total	$	42	$	40	$	36

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,
	2014			2013			2012
	*(millions of dollars)*
Current Tax Benefit
Federal	$	(79	)	$	(39	)	$	(84	)
State and local		(3	)		(1	)		(27	)

Total Current Tax Benefit		(82	)		(40	)		(111	)

Deferred Tax Expense (Benefit)
Federal		150			96			127
State and local		24			24			33
Investment tax credit amortization		—			(1	)		(1	)

Total Deferred Tax Expense		174			119			159

Total Income Tax Expense	$	92		$	79		$	48

Reconciliation of Income Tax Expense


	For the Year Ended December 31,
	2014					2013					2012
	*(millions of dollars)*
Income tax at Federal statutory rate	$	92		35.0	%	$	80		35.0	%	$	61		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		15		5.7	%		13		5.7	%		10		5.7	%
Asset removal costs		(12	)	(4.6	)%		(14	)	(6.1	)%		(11	)	(6.3	)%
Change in estimates and interest related to uncertain and effectively settled tax positions		(1	)	(0.4	)%		(3	)	(1.3	)%		(11	)	(6.3	)%
Other, net		(2	)	(0.7	)%		3		1.2	%		(1	)	(0.5	)%

Income Tax Expense	$	92		35.0	%	$	79		34.5	%	$	48		27.6	%

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, which is included above in Change in estimates and interest related to uncertain and effectively settled tax positions.

During 2012, Pepco recorded income tax benefits of $10 million (after-tax) 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.

Components of Deferred Income Tax Liabilities (Assets)


	At December 31,
	2014			2013
	*(millions of dollars)*
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	1,423		$	1,240
Pension and other postretirement benefits		103			105
Deferred taxes on amounts to be collected through future rates		59			43
Federal and state net operating losses		(186	)		(169	)
Other		180			145

Total Deferred Tax Liabilities, net		1,579			1,364
Deferred tax assets included in Current Assets		14			48

Deferred tax liabilities included in Other Current Liabilities		(9	)		—

Total Deferred Tax Liabilities, net non-current	$	1,584		$	1,412

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, 2014 and 2013. Federal and state net operating losses generally expire over 20 years from 2029 to 2034.

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


	2014			2013			2012
	*(millions of dollars)*
Balance as of January 1	$	101		$	91		$	173
Tax positions related to current year:
Additions		1			1			—
Reductions		(2	)		—			—
Tax positions related to prior years:
Additions		1			12			60
Reductions		(4	)		(3	)		(142	)(a)
Settlements		—			—			—

Balance as of December 31	$	97		$	101		$	91

(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, 2014, 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, 2014, 2013 and 2012, Pepco recognized $2 million of pre-tax interest income ($1 million after-tax), $5 million of pre-tax interest income ($3 million after-tax), and $18 million of pre-tax interest income ($11 million after-tax), respectively, as a component of income tax expense. As of December 31, 2014, 2013 and 2012, Pepco had accrued interest receivable of $9 million, $9 million and $5 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 2015, 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 August 2011, the IRS issued Revenue Procedure 2011-43 providing a safe harbor method of tax accounting for repair costs associated with electric transmission and distribution property. In September 2012, with the filing of its 2011 tax return, PHI adopted the safe harbor for the 2011 tax year. In September 2013, the IRS published final regulations regarding the tax treatment of costs incurred to acquire, produce or improve tangible property. In February 2014, the IRS issued revenue procedures that describe how taxpayers should implement the final regulations. The final repair regulations and the related revenue procedures did not modify the guidance set forth in Revenue Procedure 2011-43 that the Unit of Property for electric transmission and distribution network assets is determined by the taxpayer’s particular facts and circumstances. The final regulations did not have a material impact on Pepco’s financial statements.

Other Taxes

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


	2014		2013		2012
	*(millions of dollars)*
Gross Receipts/Delivery	$	107	$	108	$	106
Property		51		45		46
County Fuel and Energy		143		153		160
Environmental, Use and Other		62		62		60

Total	$	363	$	368	$	372

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,
	2014			2013			2012
	*(millions of dollars)*
Current Tax (Benefit) Expense
Federal	$	(7	)	$	(23	)	$	(31	)
State and local		(2	)		(10	)		(12	)

Total Current Tax Benefit		(9	)		(33	)		(43	)

Deferred Tax Expense (Benefit)
Federal		30			28			46
State and local		7			25			16
Investment tax credit amortization		—			(1	)		(1	)

Total Deferred Tax Expense		37			52			61

Total Consolidated Income Tax Expense	$	28		$	19		$	18

Reconciliation of Consolidated Income Tax Expense


	For the Year Ended December 31,
	2014					2013					2012
	*(millions of dollars)*
Income tax at Federal statutory rate	$	26		35.0	%	$	24		35.0	%	$	19		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		4		5.5	%		5		7.2	%		3		5.7	%
Change in estimates and interest related to uncertain and effectively settled tax positions		(1	)	(1.4	)		(9	)	(13.0	)%		(1	)	(1.9	)%
Plant basis adjustments		—		—			(2	)	(2.9	)%		(1	)	(1.9	)%
Investment tax credit amortization		—		—			(1	)	(1.4	)%		(1	)	(1.9	)%
Other, net		(1	)	(0.7	)%		2		2.6	%		(1	)	(1.0	)%

Consolidated Income Tax Expense	$	28		38.4	%	$	19		27.5	%	$	18		34.0	%

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 (after-tax) interest benefit in the first quarter of 2013, which is included above in Change in estimates and interest related to uncertain and effectively settled tax positions.

During 2012, ACE recorded a $1 million benefit associated with the effective settlement with the IRS with respect to the methodology used historically to calculate deductible mixed service costs.

Components of Consolidated Deferred Income Tax Liabilities (Assets)


	As of December 31,
	2014			2013
	*(millions of dollars)*
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	691		$	627
Deferred taxes on amounts to be collected through future rates		16			16
Payment for termination of purchased power contracts with NUGs		38			43
Deferred electric service and electric restructuring liabilities		71			96
Pension and other postretirement benefits		25			29
Purchased energy		1			2
Federal and state net operating losses		(26	)		(49	)
Other		39			55

Total Deferred Tax Liabilities, net		855			819
Deferred tax assets included in Current Assets		10			15
Deferred tax liabilities included in Other Current Liabilities		—			(1	)

Total Consolidated Deferred Tax Liabilities, net non-current	$	865		$	833

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, 2014 and 2013. 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


	2014			2013			2012
	*(millions of dollars)*
Balance as of January 1	$	9		$	17		$	79
Tax positions related to current year:
Additions		1			2			1
Reductions		—			—			—
Tax positions related to prior years:
Additions		5			1			8
Reductions		(2	)		(5	)		(69	)(a)
Settlements		—			(6	)		(2	)

Balance as of December 31	$	13		$	9		$	17

(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, 2014, 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, 2014, 2013 and 2012, ACE recognized $1 million of pre-tax interest income (less than $1 million after-tax), $12 million of pre-tax interest income ($7 million after-tax), and $2 million of pre-tax interest income ($1 million after-tax), respectively, as a component of income tax expense. As of December 31, 2014, 2013 and 2012, ACE had accrued interest receivable of $14 million, $14 million and $7 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 2015, 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 $6 million to $8 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 August 2011, the IRS issued Revenue Procedure 2011-43 providing a safe harbor method of tax accounting for repair costs associated with electric transmission and distribution property. In September 2012, with the filing of its 2011 tax return, PHI adopted the safe harbor for the 2011 tax year. In September 2013, the IRS published final regulations regarding the tax treatment of costs incurred to acquire, produce or improve tangible property. In February 2014, the IRS issued revenue procedures that describe how taxpayers should implement the final regulations. The final repair regulations and the related revenue procedures did not modify the guidance set forth in Revenue Procedure 2011-43 that the Unit of Property for electric transmission and distribution network assets is determined by the taxpayer’s particular facts and circumstances. The final regulations did not have a material impact on ACE’s consolidated financial statements.

Other Taxes

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


	2014			2013		2012
	*(millions of dollars)*
Gross Receipts/Delivery	$	—		$	10	$	14
Property		3			3		3
Environmental, Use and Other		(1	)		1		1

Total	$	2		$	14	$	18