Income Taxes

6 Months Ended

Jun. 30, 2012

Income Taxes

Income Taxes

12.  Income Taxes

The Company’s effective tax rate on income from continuing operations was 42.8% and 29.0% for the three months ended June 30, 2012 and 2011, respectively. The Company’s effective tax rate on income from continuing operations was 32.4% and 26.5% for the six months ended June 30, 2012 and 2011, respectively.  The significant increase in the effective tax rates for the three months and six months ended June 30, 2012 compared to the prior year periods is primarily a result of a $32 million correction of tax related to securities lending activities. See Note 1 for additional information on the out-of-period correction.

The Company is required to establish a valuation allowance for any portion of the deferred tax assets that management believes will not be realized. Included in deferred tax assets is a significant deferred tax asset relating to capital losses that have been recognized for financial statement purposes but not yet for tax return purposes. Under current U.S. federal income tax law, capital losses generally must be used against capital gain income within five years of the year in which the capital losses are recognized for tax purposes. Significant judgment is required in determining if a valuation allowance should be established, and the amount of such allowance if required. Factors used in making this determination include estimates relating to the performance of the business including the ability to generate capital gains. Consideration is given to, among other things in making this determination, (i) future taxable income exclusive of reversing temporary differences and carryforwards, (ii) future reversals of existing taxable temporary differences, (iii) taxable income in prior carryback years and (iv) tax planning strategies. Based on analysis of the Company’s tax position, management believes it is more likely than not that the Company will not realize the full benefit of certain state net operating losses and therefore a valuation allowance has been established. The valuation allowance was $5 million at both June 30, 2012 and December 31, 2011.

Included in the Company’s deferred income tax assets are tax benefits related to capital loss carryforwards of $35 million which will expire beginning December 31, 2015 and state net operating losses of $39 million which will expire beginning December 31, 2014.

As of June 30, 2012 and December 31, 2011, the Company had $103 million and $184 million, respectively, of gross unrecognized tax benefits. The significant decrease in the amount of gross unrecognized tax benefits is a result of reaching an agreement with the Internal Revenue Service (“IRS”) on the treatment of certain items under audit. If recognized, approximately $34 million and $38 million, net of federal tax benefits, of unrecognized tax benefits as of June 30, 2012 and December 31, 2011, respectively, would affect the effective tax rate.

It is reasonably possible that the total amounts of unrecognized tax benefits will change in the next 12 months. Based on the current audit position of the Company, it is estimated that the total amount of gross unrecognized tax benefits may decrease by $78 million in the next 12 months.

The Company recognizes interest and penalties related to unrecognized tax benefits as a component of the income tax provision. The Company recognized a net increase of $1 million and a net reduction of $4 million of interest and penalties for the three months and six months ended June 30, 2012, respectively. The Company recognized $49 million and $65 million of interest and penalties for the three months and six months ended June 30, 2011, respectively. At June 30, 2012 and December 31, 2011, the Company had a payable of $33 million and $37 million, respectively, related to accrued interest and penalties.

The Company or one or more of its subsidiaries files income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. The IRS had previously completed its field examination of the 1997 through 2007 tax returns in recent years as part of the overall examination of the American Express Company consolidated returns. However, for federal income tax purposes, these years, except for 2007, continue to remain open as a consequence of certain issues under appeal. The IRS is currently auditing the Company’s U.S. income tax returns for 2008 and 2009. The Company’s or certain of its subsidiaries’ state income tax returns are currently under examination by various jurisdictions for years ranging from 1999 through 2009. The Company’s federal and state income tax returns remain open for the years after 2009.