Income Taxes (EME, Midwest Generation)

EME

Current and Deferred Taxes

The provision (benefit) for income taxes is composed of the following:



	Years Ended December 31,
(in millions)	2012			2011			2010
Continuing Operations
Current
Federal	$	—		$	48		$	(321	)
State	—			(44		)	9
Total current	—			4			(312		)
Deferred
Federal	$	26		$	(389	)	$	281
State	134			(56		)	15
Total deferred	160			(445		)	296
Provision (benefit) for income taxes from continuing operations	160			(441		)	(16		)
Discontinued operations	(73		)	(411		)	44
Total	$	87		$	(852	)	$	28

EME recorded a tax benefit of $16 million in 2010 resulting from acceptance by the California Franchise Tax Board of the tax positions finalized with the Internal Revenue Service in 2009 for the tax years 1986 through 2002.

The components of income (loss) before income taxes applicable to continuing operations and discontinued operations are as follows:



	Years Ended December 31,
(in millions)	2012			2011			2010
Continuing operations	$	(637	)	$	(888	)	$	65
Discontinued operations	(185		)	(1,043		)	126
Total	$	(822	)	$	(1,931	)	$	191

The components of net accumulated deferred income tax asset (liability) were:



	December 31,
(in millions)	2012			2011
Deferred tax assets
Accrued charges and liabilities	$	234		$	303
Net operating loss carryforwards	841			326
Production tax and other credit carryforwards	254			194
Derivative instruments	49			49
Other	6			—
Total	1,384			872
Valuation allowance	(444		)	—
Net deferred tax assets	940			872
Deferred tax liabilities
Property, plant and equipment - basis differences	$	989		$	638
Deferred investment tax credit	4			5
State taxes	28			20
Other	—			6
Total	1,021			669
Deferred tax assets (liabilities), net	$	(81	)	$	203
Classification of net accumulated deferred income taxes
Included in other assets	$	—		$	205
Included in current liabilities	$	—		$	2
Included in deferred taxes and tax credits	$	81		$	—

EME's right to receive payments under the tax-allocation agreements and the timing and amount of those payments are dependent on the inclusion of EME in the consolidated income tax returns of EIX and other factors, including the amount of consolidated taxable income and net operating loss carryforwards of EIX, and other tax items of EME and other subsidiaries of EIX. Without objectively verifiable evidence supporting the taxable income forecast of the EIX consolidated tax group during 2013 and 2014, EME is not currently able to determine whether it is more likely than not that future tax-sharing payments will occur. As a result, as of December 31, 2012, EME recorded a valuation allowance against its net deferred tax assets of $444 million, of which $6 million was reflected in accumulated other comprehensive loss and $438 million in net loss for the year ended December 31, 2012. In addition, EME recorded a non-cash distribution to its parent of $222 million related to tax benefits generated by EME which have been utilized in the EIX consolidated tax return on a statutory basis for which, under the tax-allocation agreements as applied, EME is not yet, and may never be, entitled to be paid.

At December 31, 2012 amounts included in other long-term assets, payables to affiliates and other long-term liabilities associated with the tax-allocation agreements were $18 million, $33 million and $21 million, respectively. At December 31, 2011, amounts included in other long-term assets and payables to affiliates associated with the tax-allocation agreements were $86 million and $174 million, respectively.

At December 31, 2012, EME had $2,334 million of federal net operating loss carryforwards which expire in 2031 and 2032, $2,158 million of state net operating loss carryforwards which expire between 2022 and 2032, if unused. Additionally, there were $254 million of federal tax credit carryforwards of which $239 million expire between 2029 and 2032, if unused, and the remainder have no expiration date. Upon EME's exit from the EIX consolidated tax group, or if the tax-allocation agreements terminate or expire, tax benefits that had previously been generated by EME and not utilized in the EIX consolidated tax return on a statutory basis will generally be available for use by EME in its own consolidated tax return, but may be reduced as a result of cancellation of indebtedness income (COD income) or as a result of the application of the consolidated return rules. Use of such tax benefits may also further be limited upon emergence from bankruptcy as a result of the application of limitations in sections 382 or 383 of the Internal Revenue Code if there is a change of ownership of EME. At December 31, 2012, under the tax-allocation agreements as applied, EME is not yet, and may never be, entitled to be paid for either the approximately $102 million of tax benefits generated by EME which have been utilized in the EIX consolidated tax return on a statutory basis or the $120 million of payments EME has made without a corresponding statutory tax requirement. In addition, EME is not yet, and may never be, entitled to be paid for the approximately $1,071 million of tax benefits generated by EME which have not yet been utilized in the EIX consolidated tax return. Capistrano Wind Holdings and Capistrano Wind, LLC have generated $40 million of tax benefits, $16 million of which has been used by the EIX consolidated tax group, and all of which either payment has been received or payment is expected to be received under the tax-allocation agreements. Further, upon EME's exit from the EIX consolidated tax group or if the tax-allocation agreements terminate or expire, tax benefits that had been previously generated by EME and utilized in the EIX consolidated tax return on a statutory basis but are unpaid under the application of the tax-allocation agreements will not be available for use by EME in its own consolidated tax return and will not be payable under the tax-allocation agreements.

Effective Tax Rate

The table below provides a reconciliation of income tax expense (benefit) computed at the federal statutory income tax rate to the income tax provision (benefit):



	Years Ended December 31,
(in millions)	2012			2011			2010
Income (loss) from continuing operations before income taxes	$	(637	)	$	(888	)	$	65
Expense (benefit) for income taxes at federal statutory rate of 35%	$	(223	)	$	(311	)	$	23
Increase (decrease) in income tax from
State tax - net of federal benefit¹	11			(56		)	16
Change in valuation allowance	438			—			—
Production tax credits, net	(68		)	(66		)	(61		)
Qualified production deduction	—			(6		)	15
Deferred tax adjustments	—			(8		)	10
Resolution of 1986-2002 state tax issues	—			—			(16		)
Taxes on income allocated to noncontrolling interests	(4		)	—			1
Other	6			6			(4		)
Total provision (benefit) for income taxes from continuing operations	$	160		$	(441	)	$	(16	)
Effective tax rate	*			50		%	*


*	Not meaningful.


¹	Excludes state tax settlement in 2010.

Estimated state income tax benefits allocated from EIX of $3 million, $6 million and $7 million were recognized for the years ended December 31, 2012, 2011 and 2010, respectively. In the fourth quarter of 2012, EME's state tax benefit was reduced by a change in future state apportionment factors resulting from EME's exit from the EIX consolidated tax group.

Accounting for Uncertainty in Income Taxes

Unrecognized Tax Benefits

The following table provides a reconciliation of unrecognized tax benefits:



(in millions)	2012			2011		2010
Balance at January 1	$	171		$	153	$	115
Tax positions taken during the current year
Increases	—			9		—
Decreases	—			—		—
Tax positions taken during a prior year
Increases	—			9		126
Decreases	(12		)	—		(80		)
Decreases for settlements during the period	—			—		(8		)
Decreases resulting from a lapse in statute of limitations	—			—		—
Balance at December 31	$	159		$	171	$	153

As of December 31, 2012 and 2011, $154 million and $166 million, respectively, of the unrecognized tax benefits, if recognized, would impact the effective tax rate. EME believes that it is reasonably possible that unrecognized tax benefits could be reduced by an amount up to $1 million within the next 12 months.

EIX's federal income tax returns and California combined franchise tax returns are currently open for years subsequent to 2002. In addition, specific California refund claims made by EIX for years 1991 through 2002 remain subject to audit.

Accrued Interest and Penalties

The total amount of accrued interest and penalties related to EME's income tax liabilities was $65 million and $51 million as of December 31, 2012 and 2011, respectively.

The net after-tax interest and penalties recognized in income tax expense was $8 million, $10 million and $19 million for 2012, 2011 and 2010, respectively.

Tax Dispute

The Internal Revenue Service examination phase of tax years 2003 through 2006 was completed in the fourth quarter of 2010, which included a proposed adjustment related to EME. The proposed adjustment increases the taxable gain on the 2004 sale of EME's international assets, which if sustained, would result in a federal tax payment of approximately $200 million, including interest and penalties through December 31, 2012 (the Internal Revenue Service has asserted a 40% penalty for understatement of tax liability related to this matter). EME disagrees with the proposed adjustment and filed a protest with the Internal Revenue Service in the first quarter of 2011. The appeals process to date has not resulted in a change in the proposed adjustment by the Internal Revenue Service. EME continues to seek resolution through the appeals process, and has requested technical advice from the Internal Revenue Service National Office. If a deficiency notice is issued on this item, EME has 90 days to pay the tax, interest and any penalties or file a petition in United States Tax Court.

Tax Election at Homer City

On March 15, 2012, Homer City made an election to be treated as a partnership for federal and state income tax purposes. As a result of this election, Homer City is treated for tax purposes as distributing its assets and liabilities to its partners, both of which are wholly owned subsidiaries of EME, and triggering tax deductions of approximately $1 billion. Such tax deductions were included in EIX's 2011 consolidated tax returns.

Intercompany Tax-Allocation Agreement

In 2012, EME made tax-allocation payments to EIX of approximately $185 million related to the displacement, under the tax-allocation agreements, of tax benefits previously received for 2009 federal income taxes.

Midwest Generation

Current and Deferred Taxes

The provision (benefit) for income taxes is composed of the following:



	Years Ended December 31,
(in millions)	2012			2011			2010
Current
Federal	$	—		$	2		$	112
State	—			12			24
Total current	—			14			136
Deferred
Federal	$	(76	)	$	(145	)	$	7
State	14			(41		)	(1		)
Total deferred	(62		)	(186		)	6
Provision (benefit) for income taxes	$	(62	)	$	(172	)	$	142

The components of net accumulated deferred income tax asset (liability) were:



	December 31,
(in millions)	2012			2011
Deferred tax assets
State taxes	$	—		$	3
Deferred income	2			1
Derivative instruments	24			9
Impairment of loan to affiliate - tax	539			—
Property, plant and equipment - basis differences	—			15
Net operating loss carryforwards	—			19
Accrued charges and liabilities	16			9
Total	581			56
Valuation allowance	(533		)	—
Net deferred tax assets	48			56
Deferred tax liabilities
State taxes	3			—
Property, plant and equipment - basis differences	45			—
Total	48			—
Deferred tax assets, net	$	—		$	56
Classification of net accumulated deferred income taxes
Included in current assets	$	—		$	14
Included in deferred taxes	$	—		$	42

As a result of the recently recognized losses and the indications of expected future losses, Midwest Generation recorded a valuation allowance of $533 million, of which $12 million was reflected in accumulated other comprehensive loss and $521 million in net loss for the year ended December 31, 2012. In addition, Midwest Generation recognized a non-cash distribution of $106 million to reflect tax benefits that would have been collected by Midwest Generation in a hypothetical tax return prepared on a separate return basis but is not collectible under Midwest Generation's Tax Allocation Agreement. For further discussion related to non-cash distribution, see "—Intercompany Tax-Allocation Agreement."

As of December 31, 2012, on a separate return basis, Midwest Generation had $291 million of federal net operating loss carryforwards which expire in 2031 and 2032, $199 million of state net operating loss carryforwards which expire between 2025 and 2032, if unused.

Effective Tax Rate

The table below provides a reconciliation of income tax expense (benefit) computed at the federal statutory income tax rate to the income tax provision (benefit):



	Years Ended December 31,
(in millions)	2012			2011			2010
Income (loss) before income taxes	$	(1,526	)	$	(442	)	$	357
Provision (benefit) for income taxes at federal statutory rate of 35%	$	(534	)	$	(155	)	$	125
State tax, net of federal benefit	(52		)	(19		)	14
Change in valuation allowance	521			—			—
Qualified production deduction	—			—			(7		)
Deferred tax adjustments	—			—			9
Other	3			2			1
Total provision (benefit) for income taxes	$	(62	)	$	(172	)	$	142
Effective tax rate	4		%	39		%	40		%

Accounting for Uncertainty in Income Taxes

Unrecognized Tax Benefits

The following table provides a reconciliation of unrecognized tax benefits:



(in millions)	2012		2011		2010
Balance at January 1	$	44	$	44	$	—
Tax positions taken during the current year
Increases	—		—		—
Decreases	—		—		—
Tax positions taken during a prior year
Increases¹	—		—		44
Decreases	—		—		—
Decreases for settlements during the period	—		—		—
Decreases resulting from a lapse in statute of limitations	—		—		—
Balance at December 31	$	44	$	44	$	44


¹	Unrecognized tax benefits relate to tax positions taken in prior years and result from a review of Midwest Generation's deferred tax assets and liabilities.

As of December 31, 2012 and 2011, $41 million of the unrecognized tax benefits, if recognized, would impact the effective tax rate.

Accrued Interest and Penalties

The total amount of accrued interest expense and penalties was $23 million and $20 million as of December 31, 2012 and 2011, respectively. The net after-tax interest expense and penalties recognized in income tax expense was $2 million, $3 million and $10 million for 2012, 2011 and 2010, respectively.

Intercompany Tax-Allocation Agreement

Midwest Generation generated taxable losses for the year ended December 31, 2012. In a hypothetical tax return prepared on a separate company basis, Midwest Generation would be able to carryback net operating losses to prior periods and receive tax benefits. During 2012, Midwest Generation recognized $106 million of tax benefits associated with net operating losses carrybacks calculated on a hypothetical tax return under the separate return method. However, the Midwest Generation Tax Allocation Agreement only permits the use of net operating losses to offset future taxable income. Under generally accepted accounting principles applicable to the separate return method, benefits recognized on a hypothetical separate company tax return that are not paid under an intercompany tax-allocation agreement are treated as a non-cash distribution to the parent company. If Midwest Generation offsets net operating loss carryforwards against taxable income in the future, such tax benefit will be accounted for as non-cash contributions at the time of use. The liability on Midwest Generation's consolidated balance sheet associated with this tax-allocation agreement totaled $13 million at December 31, 2011 and was included in due to affiliates.

Bonus Depreciation Impact (EME, Midwest Generation)

The Small Business Jobs Act of 2010 and the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Relief Act) extended 50% bonus depreciation for qualifying property through 2012 and created a new 100% bonus depreciation for qualifying property placed in service between September 9, 2010 and December 31, 2011. Subject to updated Internal Revenue Service regulations clarifying the definitions of capital expenditures that qualify for 100% bonus depreciation, EME's and Midwest Generation's capital expenditures are expected to qualify, accelerating federal tax deductions in 2012 and 2013. The 50% bonus depreciation provisions continue for qualifying property placed in service through 2013 as a result of the American Taxpayer Relief Act signed into law on January 2, 2013.