13. Income Taxes

The following table presents our effective tax rates.


	2012					2011
	(dollars are in millions)
Three Months Ended September 30,
Tax expense (benefit) at the U.S. federal statutory income tax rate	$	(278	)	(35.0	)%	$	101		35.0	%
Increase (decrease) in rate resulting from:
State and local taxes, net of federal benefit		14		1.8			5		1.8
Valuation allowance on deferred tax assets		-		-			8		2.7
Non-deductible expense accrual related to certain regulatory matters		280		35.3			-		-
Non-deductible goodwill related to sale of branches		33		4.2			-		-
Validation of current liability accounts		(34	)	(4.3	)		-		-
Tax exempt interest income		(6	)	(.8	)		(3	)	(1.0	)
Low income housing and other tax credits		(21	)	(2.6	)		(21	)	(7.0	)
Foreign tax credits and other credits		(8	)	(1.0	)		(8	)	(3.4	)
Impact of foreign operations		8		1.0			31		11.2
Uncertain tax provision reserves		(9	)	(1.1	)		6		1.9
Other		8		1.0			(2	)	(.7	)

Effective tax rate	$	(12	)	(1.5	)%	$	117		40.5	%

Nine Months Ended September 30,
Tax expense (benefit) at the U.S. federal statutory income tax rate	$	(328	)	(35.0	)%	$	235		35.0	%
Increase (decrease) in rate resulting from:
State and local taxes, net of federal benefit		23		2.5			42		6.0
Change in tax rate used to value deferred taxes		(10	)	(1.1	)		-		-
Valuation allowance on deferred tax assets		-		-			(135	)	(19.3	)
Non-deductible expense accrual related to certain regulatory matters		525		56.0			-		-
Non-deductible goodwill related to sale of branches		139		14.8			-		-
Validation of current liability accounts		22		2.3			-		-
Tax exempt interest income		(11	)	(1.2	)		(8	)	(1.1	)
Low income housing and other tax credits		(63	)	(6.7	)		(63	)	(9.0	)
Foreign tax credits and other credits		(23	)	(2.5	)		(20	)	(3.0	)
Impact of foreign operations		23		2.5			43		6.3
Uncertain tax provision		57		6.1			151		21.5
Other		3		.4			(7	)	(.9	)

Effective tax rate	$	357		38.1	%	$	238		35.5	%

The effective tax rate for the three and nine months ended September 30, 2012 reflects non-deductible goodwill related to the branches sold to First Niagara, a non-deductible expense accrual related to certain regulatory matters, prior period adjustments to the current liability account, including the reversal of an accrued foreign tax expense related to Brazilian withholding taxes corrected in the current year, changes in the uncertain tax reserve accrual, the utilization of low income housing credits and the impact of state taxes. The effective tax rate for the nine months ended September 30, 2012 also reflects the effect of a change in state rates used to value deferred taxes. The effective tax rate for the three and nine months ended September 30, 2011 primarily reflects the impact of foreign operations, the utilization of low income housing and other tax credits, the impact of state taxes, changes in uncertain tax positions and, as it relates to the nine month period, the release of valuation allowance reserves previously established on foreign tax credits.

HSBC North America Consolidated Income Taxes We are included in HSBC North America’s consolidated Federal income tax return and in various combined state income tax returns. As such, we have entered into a tax allocation agreement with HSBC North America and its subsidiary entities (the “HNAH Group”) included in the consolidated returns which govern the current amount of taxes to be paid or received by the various entities included in the consolidated return filings. As a result, we have looked at the HNAH Group’s consolidated deferred tax assets and various sources of taxable income, including the impact of HSBC and HNAH Group tax planning strategies, in reaching conclusions on recoverability of deferred tax assets. Where a valuation allowance is determined to be necessary at the HSBC North America consolidated level, such allowance is allocated to principal subsidiaries within the HNAH Group as described below in a manner that is systematic, rational and consistent with the broad principles of accounting for income taxes.

The HNAH Group evaluates deferred tax assets for recoverability using a consistent approach which considers the relative impact of negative and positive evidence, including historical financial performance, projections of future taxable income, future reversals of existing taxable temporary differences, tax planning strategies and any available carryback capacity.

In evaluating the need for a valuation allowance, the HNAH Group estimates future taxable income based on management approved business plans, future capital requirements and ongoing tax planning strategies, including capital support from HSBC necessary as part of such plans and strategies. The HNAH Group has continued to consider the impact of the economic environment on the North American businesses and the expected growth of the deferred tax assets. This evaluation process involves significant management judgment about assumptions that are subject to change from period to period.

In conjunction with the HNAH Group deferred tax evaluation process, based on our forecasts of future taxable income, which include assumptions about the depth and severity of home price depreciation and the U.S. economic environment, including unemployment levels and their related impact on credit losses, we currently anticipate that our results of future operations will generate sufficient taxable income to allow us to realize our deferred tax assets. However, since these market conditions have created losses in the HNAH Group in recent periods and volatility in our pre-tax book income, our analysis of the realizability of the deferred tax assets significantly discounts any future taxable income expected from continuing operations and relies to a greater extent on continued capital support from our parent, HSBC, including tax planning strategies implemented in relation to such support. HSBC has indicated they remain fully committed and have the capacity and willingness to provide capital as needed to run operations, maintain sufficient regulatory capital, and fund certain tax planning strategies.

Only those tax planning strategies that are both prudent and feasible, and which management has the ability and intent to implement, are incorporated into our analysis and assessment. The primary and most significant strategy is HSBC’s commitment to reinvest excess HNAH Group capital to reduce debt funding or otherwise invest in assets to ensure that it is more likely than not that the deferred tax assets will be utilized.

Currently, it has been determined that the HNAH Group’s primary tax planning strategy, in combination with other tax planning strategies, provides support for the realization of the net deferred tax assets recorded for the HNAH Group. Such determination is based on HSBC’s business forecasts and assessment as to the most efficient and effective deployment of HSBC capital, most importantly including the length of time such capital will need to be maintained in the U.S. for purposes of the tax planning strategy.

During the first quarter of 2011, the HNAH Group identified an additional tax planning strategy that provided support for the realization of the deferred tax assets recorded for its foreign tax credits and certain state related deferred tax assets. The use of foreign tax credits is limited by the HNAH Group’s U.S. tax liability and the availability of foreign source income. The tax planning strategy included the purchase of foreign bonds and REMIC residual interests. These purchases are expected to generate sufficient foreign source taxable income to allow for the utilization of the foreign tax credits before the credits expire unused and recognition of certain state deferred tax assets.

Notwithstanding the above, the HNAH Group had valuation allowances against certain state deferred tax assets and certain Federal tax loss carry forwards for which the aforementioned tax planning strategies did not provide appropriate support.

HNAH Group valuation allowances are allocated to the principal subsidiaries, including us. The methodology allocates the valuation allowance to the principal subsidiaries based primarily on the entity’s relative contribution to the growth of the HSBC North America consolidated deferred tax asset against which the valuation allowance is being recorded.

If future results differ from the HNAH Group’s current forecasts or the tax planning strategies were to change, a valuation allowance against some or all of the remaining net deferred tax assets may need to be established which could have a material adverse effect on our results of operations, financial condition and capital position. The HNAH Group will continue to update its assumptions and forecasts of future taxable income, including relevant tax planning strategies, and assess the need for such incremental valuation allowances.

Absent the capital support from HSBC and implementation of the related tax planning strategies, the HNAH Group, including us, would be required to record a valuation allowance against the remaining deferred tax assets.

HSBC USA Inc. Income Taxes We recognize deferred tax assets and liabilities for the future tax consequences related to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for tax credits and state net operating losses. Our net deferred tax assets, including both deferred tax liabilities and valuation allowances, totaled $1.0 billion and $0.9 billion as of September 30, 2012 and December 31, 2011, respectively.

During the third quarter of 2012, the Internal Revenue Service (“IRS”) Appeals Office closed its review covering the tax periods 2004 and 2005 after the settlement was approved by the Joint Committee of Taxation. There is no resulting impact to our uncertain tax reserves.

The IRS began its audit of our 2006 and 2007 income tax returns in 2009, with an anticipated completion in 2012. The IRS began their examination of 2008 and 2009 during the third quarter of 2011, with an anticipated completion in 2013.

We remain subject to state and local income tax examinations for years 2004 and forward. We are currently under audit by various state and local tax jurisdictions. Uncertain tax positions are reviewed on an ongoing basis and are adjusted in light of changing facts and circumstances, including progress of tax audits, developments in case law and the closing of statute of limitations. Such adjustments are reflected in the tax provision. As a result of a 2011 state court decision related to a state tax uncertainty, we no longer believe that we can uphold the more likely than not conclusion taken on one of these uncertain tax positions. Therefore, tax reserves of approximately $285 million (net of federal tax benefit) and related accrued interest expense of $134 million were recorded through the third quarter of 2012 to recognize the estimated tax exposure on this matter.

It is reasonably possible that there could be a change in the amount of our unrecognized tax benefits within the next 12 months due to settlements or statutory expirations in various state and local tax jurisdictions. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate was $329 million and $276 million at September 30, 2012 and December 31, 2011.

It is our policy to recognize accrued interest related to unrecognized tax positions in interest expense in the consolidated statement of income (loss) and to recognize penalties related to unrecognized tax positions as a component of other servicing and administrative expenses in the consolidated statement of income (loss). We had accruals for the payment of interest and penalties associated with uncertain tax positions of $150 million and $130 million at September 30, 2012 and December 31, 2011.