7 . INCOME TAXES

Provisions for income taxes have been calculated in accordance with the provisions of ASC 740. A summary of the components of income before income taxes and income tax expense (benefit) in the Consolidated Statements of Income are shown below:


FOR THE YEARS ENDED DECEMBER 31	2012			2011			2010
(in millions)
Income (loss) before income taxes:
U.S.	$	(99.1	)	$	(13.3	)	$	205.6
Non-U.S.		127.8			34.9			—
	$	28.7		$	21.6		$	205.6

Income tax expense (benefit) includes the following components:


FOR THE YEARS ENDED DECEMBER 31	2012			2011			2010
(in millions)
Current:
U.S.	$	2.3		$	(0.6	)	$	5.7
Non-U.S.		16.1			—			—
Subtotal		18.4			(0.6	)		5.7
Deferred:
U.S.		(42.7	)		(20.3	)		50.3
Non-U.S.		6.9			11.0			—
Subtotal		(35.8	)		(9.3	)		50.3
Total income tax expense (benefit)	$	(17.4	)	$	(9.9	)	$	56.0

The income tax expense attributable to the consolidated results of continuing operations is different from the amount determined by multiplying income from continuing operations before income taxes by the U.S. statutory federal income tax rate of 35%. The sources of the difference and the tax effects of each were as follows:


FOR THE YEARS ENDED DECEMBER 31	2012		2011		2010
(in millions)
Expected income tax expense	$	10.0	$	7.5	$	72.0
Tax difference related to investment disposals and maturities		(14.3)		(9.7)		(3.2)
Change in valuation allowance		(7.7)		(7.5)		(57.1)
Effect of foreign operations		(3.9)		(1.5)		—
Dividend received deduction		(2.8)		(1.1)		(0.8)
Nondeductible expenses		2.8		4.7		0.5
Expired capital loss carryforward		—		—		47.4
Tax-exempt interest		(1.5)		(2.0)		(2.2)
Tax credits		—		(0.2)		(0.4)
Other, net		—		(0.1)		(0.2)
Income tax expense (benefit)	$	(17.4)	$	(9.9)	$	56.0
Effective tax rate		(60.6)%		(45.8)%		27.2%

The following are the components of the Company’s deferred tax assets and liabilities (excluding those associated with its discontinued operations).


DECEMBER 31	2012		2011
(in millions)
Deferred tax assets
Loss, LAE and unearned premium reserves, net	$	190.6	$	178.9
Tax credit carryforwards		126.8		112.2
Operating loss carryforwards		75.1		79.8
Employee benefit plans		56.4		45.6
Deferred Lloyd’s underwriting losses		13.5		18.6
Investments, net		—		9.3
Other		60.7		63.0
		523.1		507.4
Less: Valuation allowance		—		35.9
		523.1		471.5
Deferred tax liabilities
Deferred policy acquisition costs		115.8		109.7
Investments, net		43.3		—
Software capitalization		31.4		29.9
Deferred foreign sourced income		8.0		—
Other		57.0		57.9
		255.5		197.5
Net deferred tax asset	$	267.6	$	274.0

Deferred tax assets are reduced by a valuation allowance if it is more likely than not that all or some portion of the deferred tax assets will not be realized.

Included in the Company’s deferred tax asset as of December 31, 2012 are assets of $58.4 million related to U.S. net operating loss carryforwards and a deferred tax asset of $16.7 million related to foreign net operating carryforwards. The pre-tax U.S. operating loss carryforwards of $166.8 million will expire beginning in 2031. The pre-tax foreign operating loss carryforwards of $70.7 million were generated in the U.K. and have no expiration date. It is the Company’s opinion that there will be sufficient future U.S. and U.K. taxable income to utilize these loss carryforwards. The Company’s estimate of the gross amount and likely realization of loss carryforwards may change over time. At December 31, 2012, the Company has fully utilized its deferred tax asset related to U.S. capital loss carryforwards.

Included in the Company’s deferred tax asset as of December 31, 2012 are assets of $112.2 million related to alternative minimum tax credit carryforwards and $14.6 million related to foreign tax credit carryforwards. The alternative minimum tax credit carryforwards have no expiration date and the foreign tax credit carryforwards will expire beginning in 2021. The Company may utilize the credits to offset regular federal income taxes due from future income, and although the Company believes that these assets are fully recoverable, there can be no certainty that future events will not affect their recoverability. The Company believes, based on objective evidence, the remaining deferred tax assets will be realized.

In June 2012, the Company completed a transaction which resulted in the realization, for tax purposes only, of unrealized gains in its investment portfolio of $69.6 million. This transaction enabled the Company to realize capital loss carryforwards to offset this gain, and resulted in the release of $24.4 million of the valuation allowance held against the deferred tax asset related to these capital loss carryforwards. Of the total $24.4 million release, $0.3 million was recorded as an increase in continuing operations and $24.1 million is reflected as a benefit in accumulated other comprehensive income. This $24.1 million will be released into income from continuing operations, related to non-segment income, in future years, as the investment securities subject to these transactions are sold or mature.

During 2012, the Company released $35.9 million of its valuation allowance related to its deferred tax asset held at the beginning of the year. The release of this valuation allowance resulted from the aforementioned transaction which utilized capital loss carryforwards, unrealized appreciation in its investment portfolio, and net realized capital gains in its Consolidated Statements of Income. Accordingly, the Company recorded decreases in its valuation allowance of $25.3 million as an adjustment to accumulated other comprehensive income, $7.7 million as an adjustment to income tax expense from continuing operations, and $2.9 million in discontinued operations.

In September 2011, the Company completed a transaction which resulted in the realization, for tax purposes only, of unrealized gains in its investment portfolio of $98.4 million. This transaction enabled the Company to realize capital loss carryforwards to offset this gain, and resulted in the release of $29.0 million of the valuation allowance held against the deferred tax asset related to these capital loss carryforwards. The release of $0.2 million was reflected in income from continuing operations and the remaining amount of $28.8 million was reflected as a benefit in accumulated other comprehensive income. During 2012, the Company recognized $1.4 million of the $28.8 million in income from continuing operations related to non-segment income. The remaining amount will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.

During 2011, the Company reduced its valuation allowance, for both continuing and discontinued operations, related to its deferred tax asset by $55.6 million, from $91.5 million to $35.9 million. There were four principal components to this reduction. First, the Company decreased its valuation allowance by $29.0 million as a result of the aforementioned transaction, which utilized the capital loss carryforwards. Second, the Company decreased its valuation allowance by $21.9 million on certain unrealized losses as a result of unrealized appreciation in its investment portfolio. This decrease was reflected as an increase in accumulated other comprehensive income. Third, as a result of $28.1 million in net realized gains during 2011, the Company decreased its valuation allowance by $7.5 million as an increase to income from continuing operations, since these gains utilized the Company’s capital loss carryforwards. Fourth, in the 2010 U.S. federal income tax return the Company was able to utilize an additional $7.6 million of capital loss carryforward that expired in 2010. As such, the valuation allowance was increased by $2.6 million with an equal and offsetting increase to the related deferred tax asset. The remaining increase of $0.2 million was attributable to other items reflected as an expense from discontinued operations.

In January, July, September, and December 2010, the Company completed transactions which resulted in the realization, for tax purposes only, of unrealized gains in its investment portfolio of $98.4 million, $37.1 million, $31.1 million, and $120.8 million, respectively. These transactions enabled the Company to realize capital loss carryforwards to offset these gains, and resulted in the release of $66.2 million and $34.4 million in 2010 and 2009, respectively, of the valuation allowance it held against its deferred tax asset related to these capital loss carryforwards. The total release of $100.6 million was accounted for as an increase in income from continuing operations of $3.2 million and $6.0 million in 2010 and 2009, respectively, with the remaining $91.4 million reflected as a benefit in accumulated other comprehensive income at December 31, 2010. During 2012 and 2011, the Company recognized $12.6 million and $9.5 million, respectively, of the $91.4 million in income from continuing operations related to non-segment income. The remaining amount will be released into income from continuing operations in future years, as the investment securities subject to these transactions are sold or mature.

During 2010, the Company reduced its valuation allowance, for both continuing and discontinued operations, related to its deferred tax assets by $104.1 million, from $195.6 million to $91.5 million. There were four principal components to this reduction. First, the Company reduced the valuation allowance by $66.2 million as a result of the aforementioned transactions, which utilized the capital loss carryforwards. Second, the Company increased its valuation allowance by $20.3 million for certain tax basis unrealized losses which the Company did not believe it could utilize. This increase was reflected as a decrease in accumulated other comprehensive income. Third, $135.5 million of the capital loss carryforwards expired in 2010. As a result, the Company released $47.4 million of its valuation allowance attributable to these expirations with an equal and offsetting reduction in the related deferred tax asset. Fourth, as a result of $29.7 million in net realized gains during 2010, the Company decreased its valuation allowance by $9.7 million as an increase to income from continuing operations, since these gains utilized the Company’s capital loss carryforwards. The remaining $1.1 million decrease was attributable to other items reflected as income from discontinued operations.

Although most of the Company’s non – U.S. income is subject to U.S. federal income tax, certain of its non-U.S. income is not subject to U.S. federal income tax until repatriated. Foreign taxes on this non – U.S. income are accrued at the local foreign tax rate, as opposed to the higher U.S. statutory tax rate, since these earnings currently are expected to be permanently reinvested overseas. This assumption could change, as a result of a sale of the subsidiaries, the receipt of dividends from the subsidiaries, a change in management’s intentions, or as a result of various other events. The Company has not made a provision for U.S. taxes on $10.0 million and $4.2 million of non-U.S. income for 2012 and 2011, respectively. However, in the future, if such earnings were distributed to the Company, taxes of $5.0 million would be payable on such undistributed earnings and would be reflected in the tax provision for the year in which these earnings are no longer intended to be permanently reinvested overseas, assuming all foreign tax credits are realized.

The beginning and ending liability for uncertain tax positions was $0.8 million for the years ended December 31, 2012, 2011 and 2010.

In September 2009, as part of the audit of 2005 and 2006, the IRS issued a Revenue Agents Report (“RAR”) which disallowed the dividends received deduction related to separate account assets for both 2005 and 2006. The Company challenged the disallowance by filing a formal protest and requested an IRS Appeals Conference. In 2011, the Company received written notification from the IRS Appeals Division reflecting a proposed settlement including a concession of the separate account dividends received deduction issue. As a result of the proposed settlement with the IRS, the liability for uncertain tax position on the Company’s dividends received deductions related to separate account assets was reduced in 2011. This reduction was partially offset by the settlement of certain receivable balances. The net tax benefit of $2.1 million was recorded as income from discontinued operations.

There are no tax positions at December 31, 2012 and 2011 for which the ultimate deductibility is highly certain, but for which there is uncertainty about the timing of such deductibility. Included in the December 31, 2010 balance is a $3.6 million receivable which was part of the aforementioned 2005 and 2006 proposed settlement.

The Company recognizes interest and penalties related to unrecognized tax benefits in federal income tax expense. In 2011, as part of the settlement of the 2005 and 2006 audit period, the Company reduced its accrued interest by $0.7 million. The Company had accrued interest of $0.4 million and $0.3 million as of December 31, 2012 and 2011, respectively. The Company has not recognized any penalties associated with unrecognized tax benefits.

The Company or its subsidiaries files income tax returns in the U.S. federal jurisdiction and various state jurisdictions, as well as foreign jurisdictions. With few exceptions, the Company and its subsidiaries are no longer subject to U.S. federal income tax examinations by tax authorities for years before 2007. The IRS audits of the years 2009 and 2010 commenced in June 2012 and audits of the years 2007 and 2008 commenced in April 2010. In 2011, the Company received a RAR for the 2007 and 2008 IRS audit. The Company agreed to all proposed adjustments other than a disallowance of deduction for certain loss reserves, for which it filed a formal protest and is currently working through the IRS Appeals process. The Company believes it will ultimately prevail on this issue and accordingly has not recorded any liabilities for uncertain tax positions. The effect of the proposed disallowance of deductions for certain reserves, if sustained, only impacts the timing of such deduction and does not materially affect the Company’s financial position. The Company and its subsidiaries are still subject to U.S. state income tax examinations by tax authorities for years after 2006 and foreign examinations for years after 2009.