(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,
	2015			2014			2013
	(millions of dollars)
Current Tax (Benefit) Expense
Federal	$	(3	)	$	(137	)	$	(128	)
State and local		12			(26	)		(9	)

Total Current Tax Expense (Benefit)		9			(163	)		(137	)


Deferred Tax Expense (Benefit)
Federal		92			261			393
State and local		30			41			65
Investment tax credit amortization		(2	)		(1	)		(2	)

Total Deferred Tax Expense		120			301			456

Total Consolidated Income Tax Expense Related to Continuing Operations	$	129		$	138		$	319

Reconciliation of Consolidated Income Tax Expense – Continuing Operations


	For the Year Ended December 31,
	2015					2014					2013
	(millions of dollars)
Income tax at Federal statutory rate	$	156		35.0	%	$	133		35.0	%	$	150		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		27		6.0	%		23		6.1	%		27		6.3	%
Asset removal costs		(14	)	(3.1	)%		(12	)	(3.2	)%		(14	)	(3.3	)%
Change in estimates and interest related to uncertain and effectively settled tax positions		(46	)	(10.3	)%		—		—			56		13.1	%
Deferred tax basis adjustments		7		1.6	%		—		—			—		—
Establishment of valuation allowances related to deferred tax assets		—		—			—		—			101		23.5	%
Merger related costs		4		0.9	%		7		1.8	%		—		—
Other, net		(5	)	(1.2	)%		(13	)	(3.4	)%		(1	)	(0.2	)%

Consolidated Income Tax Expense Related to Continuing Operations	$	129		28.9	%	$	138		36.3	%	$	319		74.4	%

Global Tax Settlement

On November 18, 2015, PHI entered into a settlement with the IRS and the DOJ (the Global Tax Settlement) to provide for the resolution of the tax treatment of its previously held cross-border energy lease investments involving public utility assets located outside of the United States structured as sale-in, lease-out, or SILO, transactions. The Global Tax Settlement followed the acceptance by PHI on October 29, 2015 of IRS revenue agent reports covering adjustments incorporated in the terms of the Global Tax Settlement, as well as adjustments for all other tax matters in dispute with the IRS. Also, on November 18, 2015, the DOJ accepted PHI’s offer letter for the settlement of litigation related to the SILO transactions discussed further in Note (16), “Commitments and Contingencies – PHI’s Cross-Border Energy Lease Investments.” The Global Tax Settlement and the revenue agent reports, together, effectively close all years open to examination of federal income tax liabilities for PHI through 2011, and all matters associated with the cross-border energy lease investments through 2013.

The Global Tax Settlement, which resolves tax matters related to the cross-border energy lease investments and avoids the costs associated with continued litigation, provides that all depreciation and interest deductions in excess of rental income related to the cross-border energy lease investments were disallowed. The Global Tax Settlement also required PHI to recognize original issue discount income for tax purposes associated with the recharacterization of each of the leases as a loan transaction. Pursuant to the Global Tax Settlement, interest will be assessed with respect to tax underpayments in the relevant years; however, no penalties were assessed against PHI. The Global Tax Settlement provides for the same treatment of the cross-border energy lease investments for the tax years 2012 and 2013 as described above. The last of PHI’s cross-border energy lease investments was terminated in 2013. As a result of the Global Tax Settlement, PHI and the DOJ filed stipulations of dismissal regarding the litigation in the U.S. Court of Federal Claims. The Court dismissed the complaint on November 20, 2015.

As a result of the Global Tax Settlement, PHI recorded in the fourth quarter of 2015 a tax benefit of $56 million, including $47 million associated with continuing operations and $9 million associated with discontinued operations. The $47 million benefit associated with continuing operations is included above in Change in estimates and interest related to uncertain and effectively settled tax positions. Included in the tax benefit of $47 million associated with continuing operations was a $21 million after-tax interest benefit representing the anticipated reduction in previously recorded interest expense that was allocated to PHI’s continuing operations associated with PHI’s uncertain tax positions. The remaining tax benefit recorded of $26 million primarily represents uncertain tax positions associated with PHI’s continuing operations that were settled in favor of PHI in the Global Tax Settlement.

Also during the fourth quarter of 2015, PHI completed its annual reconciliation of its deferred income tax accounts and corrected prior period errors by recording an after-tax charge of $7 million which is included above in Deferred tax basis adjustments. Management has determined that these errors, individually or in the aggregate, were not material to the current or prior periods.

Other Tax Matters

During 2015 and 2014, PHI recorded tax benefits of $6 million and $5 million, respectively, related to certain energy efficiency tax deductions associated with Pepco Energy Services’ energy savings performance contracting services. Theses tax benefits are included above in Other, net.

In connection with the proposed Merger (as further described in Note (1), “Organization”), PHI incurred certain merger-related costs in 2015 and 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.

Components of Consolidated Deferred Tax Liabilities (Assets)


	At December 31,
	2015			2014
	*(millions of dollars)*
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	3,273		$	2,962
Deferred electric service and electric restructuring liabilities		43			67
Federal and state net operating losses		(446	)		(400	)
Valuation allowances on state net operating losses		63			61
Pension and other postretirement benefits		92			116
Deferred taxes on amounts to be collected through future rates		86			94
Other		267			325

Total Deferred Tax Liabilities, net		3,378			3,225
Deferred tax assets included in Other Assets		15			17

Total Consolidated Deferred Tax Liabilities, net	$	3,393		$	3,242

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


	2015			2014			2013
	*(millions of dollars)*

Balance as of January 1,	$	850		$	831		$	200
Tax positions related to current year:
Additions		—			4			3
Reductions		—			(2	)		—
Tax positions related to prior years:
Additions		13			27			646	(b)
Reductions		(201	)(a)		(10	)		(12	)
Settlements		(628	)(a)		—			(6	)

Balance as of December 31,	$	34		$	850		$	831

(a)

Reductions and settlements in 2015 resulted from the Global Tax Settlement. Settlements represent unrecognized tax benefits that were satisfied with cash or use of net operating losses and tax credits. The majority of the settlements were associated with the treatment of the former cross-border energy lease investments of PCI.

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

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, 2015 included $22 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, 2015, 2014 and 2013, PHI recognized $35 million of pre-tax interest income ($21 million after-tax), less than $1 million of pre-tax interest expense, and $125 million of pre-tax interest expense ($75 million after-tax), respectively, as a component of income tax expense related to continuing and discontinued operations. As of December 31, 2015, 2014 and 2013, PHI had accrued interest payable of $2 million, accrued interest receivable of $2 million and accrued interest receivable of $2 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. At this time, it is estimated that there will be a $6 million to $10 million decrease in unrecognized tax benefits within the next 12 months.

Tax Years Open to Examination

As a result of the Global Tax Settlement, PHI’s federal income tax liabilities for PHI and Pepco legacy companies for all years through 2011, and for all matters associated with the cross-border energy lease investments for all years through 2013, 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. 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.

Changes to the District of Columbia Tax Law

On February 26, 2015, the District of Columbia Fiscal Year 2015 Budget Support Act of 2014 became law, effective January 1, 2015. The law revised the apportionment methodology for corporate tax and included a phase-down of the corporate tax rate from 9.975% to 8.25% by fiscal year 2019. The change in law required PHI and Pepco to remeasure their net deferred tax liabilities in the first and fourth quarters of 2015. This remeasurement resulted in Pepco reducing its deferred tax liabilities by $23 million in the first quarter of 2015 to reflect the initial reduction in the tax rate from 9.975% to 9.4% on January 1, 2015 and $2 million in the fourth quarter of 2015 to reflect the subsequent reduction in the tax rate from 9.4% to 9.2% on January 1, 2016. These reductions to the deferred tax liabilities were offset by corresponding decreases to Pepco’s regulatory assets. Further reductions to the corporate tax rate in future years will depend upon the achievement of future revenue projections for the District of Columbia.

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 $421 million, $407 million and $422 million for the years ended December 31, 2015, 2014 and 2013, respectively, related to Power Delivery, which are recoverable through rates.


	2015		2014		2013
	*(millions of dollars)*
Gross Receipts/Delivery	$	124	$	123	$	133
Property		92		84		77
County Fuel and Energy		143		143		153
Environmental, Use and Other		68		63		65

Total	$	427	$	413	$	428

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,
	2015			2014			2013
	*(millions of dollars)*
Current Tax Benefit
Federal	$	(57	)	$	(79	)	$	(39	)
State and local		6			(3	)		(1	)

Total Current Tax Benefit		(51	)		(82	)		(40	)

Deferred Tax Expense (Benefit)
Federal		125			150			96
State and local		24			24			24
Investment tax credit amortization		—			—			(1	)

Total Deferred Tax Expense		149			174			119

Total Income Tax Expense	$	98		$	92		$	79

Reconciliation of Income Tax Expense


	For the Year Ended December 31,
	2015					2014					2013
	*(millions of dollars)*

Income tax at Federal statutory rate	$	100		35.0	%	$	92		35.0	%	$	80		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		15		5.3	%		15		5.7	%		13		5.7	%
Asset removal costs		(14	)	(4.9	)%		(12	)	(4.6	)%		(14	)	(6.1	)%
Change in estimates and interest related to uncertain and effectively settled tax positions		(6	)	(2.1	)%		(1	)	(0.4	)%		(3	)	(1.3	)%
Deferred tax basis adjustments		6		2.1	%		—		—			—		—
Other, net		(3	)	(1.0	)%		(2	)	(0.7	)%		3		1.2	%

Income Tax Expense	$	98		34.4	%	$	92		35.0	%	$	79		34.5	%

Global Tax Settlement

On November 18, 2015, PHI entered into a settlement with the Internal Revenue Service (IRS) and the Department of Justice (DOJ) (the Global Tax Settlement) to provide for the resolution of the tax treatment of its previously held cross-border energy lease investments involving public utility assets located outside of the United States structured as sale-in, lease-out, or SILO, transactions. The Global Tax Settlement followed the acceptance by PHI on October 29, 2015 of IRS revenue agent reports covering adjustments incorporated in the terms of the Global Tax Settlement, as well as adjustments for all other tax matters in dispute with the IRS. The Global Tax Settlement and the revenue agent reports, together, effectively close all years open to examination of federal income tax liabilities for PHI and Pepco through 2011, and all matters associated with the cross-border energy lease investments through 2013.

As a result of the Global Tax Settlement, Pepco recorded in the fourth quarter of 2015 a tax benefit of $9 million, which is included above in Change in estimates and interest related to uncertain and effectively settled tax positions. Included in the tax benefit of $9 million was a $3 million after-tax interest benefit associated with Pepco’s uncertain tax positions. The interest benefit represented Pepco’s allocated share of an overall net interest benefit for PHI’s consolidated group of $21 million resulting from the Global Tax Settlement assuming Pepco was a separate taxpayer. The remaining tax benefit recorded of $6 million primarily represents uncertain tax positions associated with Pepco’s operations that were settled in favor of Pepco in the Global Tax Settlement. Also in the fourth quarter of 2015, Pepco recorded a charge of $3 million for an uncertain tax position not related to the Global Tax Settlement, which was also included above in Change in estimates and interest related to uncertain and effectively settled tax positions.

Also during the fourth quarter of 2015, Pepco completed its annual reconciliation of its deferred income tax accounts and corrected prior period errors by recording an after-tax charge of $6 million which is included above in Deferred tax basis adjustments. Management has determined that these errors, individually or in the aggregate were not material to the current or prior periods.

Other Tax Matter

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.

Components of Deferred Income Tax Liabilities (Assets)


	At December 31,
	2015			2014
	*(millions of dollars)*

Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	1,541		$	1,423
Pension and other postretirement benefits		95			103
Deferred taxes on amounts to be collected through future rates		55			59
Federal and state net operating losses		(141	)		(186	)
Other		171			180

Total Deferred Tax Liabilities, net	$	1,721		$	1,579

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, 2015 and 2014. 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


	2015			2014			2013
	*(millions of dollars)*

Balance as of January 1	$	97		$	101		$	91
Tax positions related to current year:
Additions		—			1			1
Reductions		—			(2	)		—
Tax positions related to prior years:
Additions		10			1			12
Reductions		(55	)(a)		(4	)		(3	)
Settlements		(40	)(a)		—			—

Balance as of December 31	$	12		$	97		$	101

(a)	Reductions and settlements in 2015 resulted from the Global Tax Settlement. Settlements represent unrecognized tax benefits that were satisfied with cash or use of net operating losses and tax credits.

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, 2015, 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, 2015, 2014 and 2013, Pepco recognized $5 million of pre-tax interest income ($3 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. As of December 31, 2015, 2014 and 2013, Pepco had accrued interest receivable of zero, $9 million and $9 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. At this time, it is estimated that there will be a $3 million to $5 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. As a result of the Global Tax Settlement described above, Pepco’s federal income tax liabilities for all years through 2011 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 or intends to file amended state returns requesting refunds which are subject to review by the various states.

Changes to the District of Columbia Tax Law

On February 26, 2015, the District of Columbia Fiscal Year 2015 Budget Support Act of 2014 became law, effective January 1, 2015. The law revised the apportionment methodology for corporate tax and included a phase-down of the corporate tax rate from 9.975% to 8.25% by fiscal year 2019. The change in law required PHI and Pepco to remeasure their net deferred tax liabilities in the first and fourth quarters of 2015. This remeasurement resulted in Pepco reducing its deferred tax liabilities by $23 million in the first quarter of 2015 to reflect the initial reduction in the tax rate from 9.975% to 9.4% on January 1, 2015 and $2 million in the fourth quarter of 2015 to reflect the subsequent reduction in the tax rate from 9.4% to 9.2% on January 1, 2016. These reductions to the deferred tax liabilities were offset by corresponding decreases to Pepco’s regulatory assets. Further reductions to the corporate tax rate in future years will depend upon the achievement of future revenue projections for the District of Columbia.

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.


	2015		2014		2013
	*(millions of dollars)*
Gross Receipts/Delivery	$	107	$	107	$	108
Property		55		51		45
County Fuel and Energy		143		143		153
Environmental, Use and Other		64		62		62

Total	$	369	$	363	$	368

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,
	2015			2014			2013
	*(millions of dollars)*

Current Tax (Benefit) Expense
Federal	$	(26	)	$	(45	)	$	(8	)
State and local		2			—			—

Total Current Tax Benefit		(24	)		(45	)		(8	)

Deferred Tax Expense (Benefit)
Federal		73			99			53
State and local		1			12			12
Investment tax credit amortization		(1	)		(1	)		(1	)

Total Deferred Tax Expense		73			110			64

Total Income Tax Expense	$	49		$	65		$	56

Reconciliation of Income Tax Expense


	For the Year Ended December 31,
	2015					2014					2013
	*(millions of dollars)*

Income tax at Federal statutory rate	$	44		35.0	%	$	59		35.0	%	$	51		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		7		5.6	%		9		5.3	%		8		5.5	%
Change in estimates and interest related to uncertain and effectively settled tax positions		3		2.4	%		—		—			(1	)	(0.7	)%
Other, net		(5	)	(3.8	)%		(3	)	(1.8	)%		(2	)	(1.2	)%

Income Tax Expense	$	49		39.2	%	$	65		38.5	%	$	56		38.6	%

Global Tax Settlement

On November 18, 2015, PHI entered into a settlement with the Internal Revenue Service (IRS) and the Department of Justice (DOJ) (the Global Tax Settlement) to provide for the resolution of the tax treatment of its previously held cross-border energy lease investments involving public utility assets located outside of the United States structured as sale-in, lease-out, or SILO, transactions. The Global Tax Settlement followed the acceptance by PHI on October 29, 2015 of IRS revenue agent reports covering adjustments incorporated in the terms of the Global Tax Settlement, as well as adjustments for all other tax matters in dispute with the IRS. The Global Tax Settlement and the revenue agent reports, together, effectively close all years open to examination of federal income tax liabilities for PHI and DPL through 2011, and all matters associated with the cross-border energy lease investments through 2013.

As a result of the Global Tax Settlement, DPL recorded in the fourth quarter of 2015 tax expense of $3 million which is included above in Change in estimates and interest related to uncertain and effectively settled tax positions. The tax charge recorded of $3 million primarily represents uncertain tax positions that were settled in favor of the IRS in the Global Tax Settlement. Included in the tax expense of $3 million was an after-tax interest benefit of less than $1 million associated with DPL’s uncertain tax positions. The interest benefit represented DPL’s allocated share of an overall net interest benefit for PHI’s consolidated group of $21 million resulting from the Global Tax Settlement assuming DPL was a separate taxpayer.

Other Tax Matter

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 Change in estimates and interest related to uncertain and effectively settled tax positions.

Components of Deferred Income Tax Liabilities (Assets)


	As of December 31,
	2015			2014
	*(millions of dollars)*
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	899		$	797
Deferred taxes on amounts to be collected through future rates		15			19
Federal and state net operating losses		(122	)		(115	)
Pension and other postretirement benefits		75			80
Electric restructuring liabilities		(4	)		(4	)
Other		78			101

Total Deferred Tax Liabilities, net	$	941		$	878

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, 2015 and 2014. 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


	2015			2014			2013
	*(millions of dollars)*
Balance as of January 1	$	22		$	9		$	9
Tax positions related to current year:
Additions		—			1			—
Reductions		—			—			—
Tax positions related to prior years:
Additions		3			13			—
Reductions		(13	)(a)		(1	)		—
Settlements		(9	)(a)		—			—

Balance as of December 31	$	3		$	22		$	9

(a)	Reductions and settlements in 2015 resulted from the Global Tax Settlement. Settlements represent unrecognized tax benefits that were satisfied with cash or use of net operating losses and tax credits.

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, 2015, DPL had $3 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, 2015, 2014 and 2013, DPL recognized less than $1 million of pre-tax interest income as a component of income tax expense. As of December 31, 2015, 2014 and 2013, DPL had accrued interest receivable of zero, $2 million and $2 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. At this time, it is estimated that there will be no 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. As a result of the Global Tax Settlement described above, DPL’s federal income tax liabilities for all years through 2011 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.


	2015		2014		2013
	*(millions of dollars)*
Gross Receipts/Delivery	$	17	$	16	$	15
Property		28		24		24
Environmental, Use and Other		2		2		1

Total	$	47	$	42	$	40

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,
	2015			2014			2013
	*(millions of dollars)*
Current Tax (Benefit) Expense
Federal	$	(2	)	$	(7	)	$	(23	)
State and local		3			(2	)		(10	)

Total Current Tax Benefit		1			(9	)		(33	)

Deferred Tax Expense (Benefit)
Federal		25			30			28
State and local		5			7			25
Investment tax credit amortization		—			—			(1	)

Total Deferred Tax Expense		30			37			52

Total Consolidated Income Tax Expense	$	31		$	28		$	19

Reconciliation of Consolidated Income Tax Expense


	For the Year Ended December 31,
	2015					2014					2013
	*(millions of dollars)*
Income tax at Federal statutory rate	$	24		35.0	%	$	26		35.0	%	$	24		35.0	%
Increases (decreases) resulting from:
State income taxes, net of federal effect		4		5.8	%		4		5.5	%		5		7.2	%
Change in estimates and interest related to uncertain and effectively settled tax positions		3		4.3	%		(1	)	(1.4	)%		(9	)	(13.0	)%
Deferred tax basis adjustments		2		2.9	%		—		—			(2	)	(2.9	)%
Investment tax credit amortization		—		—			—		—			(1	)	(1.4	)%
Other, net		(2	)	(3.1	)%		(1	)	(0.7	)%		2		2.6	%

Consolidated Income Tax Expense	$	31		44.9	%	$	28		38.4	%	$	19		27.5	%

Global Tax Settlement

On November 18, 2015, PHI entered into a settlement with the IRS and the Department of Justice (DOJ) (the Global Tax Settlement) to provide for the resolution of the tax treatment of its previously held cross-border energy lease investments involving public utility assets located outside of the United States structured as sale-in, lease-out, or SILO, transactions. The Global Tax Settlement followed the acceptance by PHI on October 29, 2015 of IRS revenue agent reports covering adjustments incorporated in the terms of the Global Tax Settlement, as well as adjustments for all other tax matters in dispute with the IRS. The Global Tax Settlement and the revenue agent reports, together, effectively close all years open to examination of federal income tax liabilities for PHI and ACE through 2011, and all matters associated with the cross-border energy lease investments through 2013.

As a result of the Global Tax Settlement, ACE recorded in the fourth quarter of 2015 tax expense of $3 million which is included above in Change in estimates and interest related to uncertain and effectively settled tax positions. The tax charge recorded of $3 million primarily represents uncertain tax positions that were settled in favor of the IRS in the Global Tax Settlement. Included in the tax expense of $3 million was after-tax interest expense of less than $1 million associated with ACE’s uncertain tax positions. The interest expense represented ACE’s allocated share of an overall net interest benefit for PHI’s consolidated group of $21 million resulting from the Global Tax Settlement assuming ACE was a separate taxpayer.

Also during the fourth quarter of 2015, ACE completed its annual reconciliation of its deferred income tax accounts and corrected prior period errors by recording an after-tax charge of $2 million which is included above in Deferred tax basis adjustments. Management has determined that these errors, individually or in the aggregate, were not material to the current or prior periods.

Other Tax Matter

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.

Components of Consolidated Deferred Income Tax Liabilities (Assets)


	As of December 31,
	2015			2014
	*(millions of dollars)*
Deferred Tax Liabilities (Assets)
Depreciation and other basis differences related to plant and equipment	$	773		$	691
Deferred taxes on amounts to be collected through future rates		17			16
Payment for termination of purchased power contracts with NUGs		34			38
Deferred electric service and electric restructuring liabilities		47			71
Pension and other postretirement benefits		20			25
Federal and state net operating losses		(9	)		(26	)
Other		6			40

Total Consolidated Deferred Tax Liabilities, net	$	888		$	855

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, 2015 and 2014. 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


	2015			2014			2013
	*(millions of dollars)*
Balance as of January 1	$	13		$	9		$	17
Tax positions related to current year:
Additions		—			1			2
Reductions		—			—			—
Tax positions related to prior years:
Additions		—			5			1
Reductions		(10	)(a)		(2	)		(5	)
Settlements		(3	)(a)		—			(6	)

Balance as of December 31	$	—		$	13		$	9

(a)	Reductions and settlements in 2015 resulted from the Global Tax Settlement. Settlements represent unrecognized tax benefits that were satisfied with cash or use of net operating losses and tax credits.

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, 2015, 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, 2015, 2014 and 2013, ACE recognized less than $1 million of pre-tax interest income (less than $1 million after-tax), $1 million of pre-tax interest income (less than $1 million after-tax), and $12 million of pre-tax interest income ($7 million after-tax), respectively, as a component of income tax expense. As of December 31, 2015, 2014 and 2013, ACE had accrued interest receivable of zero, $14 million and $14 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. At this time, it is estimated that there will no 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. As a result of the Global Tax Settlement described above, ACE’s federal income tax liabilities for all years through 2011 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.

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.


	2015		2014			2013
	*(millions of dollars)*
Gross Receipts/Delivery	$	—	$	—		$	10
Property		4		3			3
Environmental, Use and Other		1		(1	)		1

Total	$	5	$	2		$	14