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:


YEARS ENDED DECEMBER 31	2013		2012			2011
*(in millions)*
Income (loss) before income taxes:
U.S.	$	183.5	$	(99.1	)	$	(13.3	)
Non-U.S.		145.6		127.8			34.9

	$	329.1	$	28.7		$	21.6

Income tax expense (benefit) includes the following components:


YEARS ENDED DECEMBER 31	2013		2012			2011
*(in millions)*
Current:
U.S.	$	8.0	$	2.3		$	(0.6	)
Non-U.S.		0.6		16.1			—

Subtotal		8.6		18.4			(0.6	)

Deferred:
U.S.		52.9		(42.7	)		(20.3	)
Non-U.S.		21.9		6.9			11.0

Subtotal		74.8		(35.8	)		(9.3	)

Total income tax expense (benefit)	$	83.4	$	(17.4	)	$	(9.9	)

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:


YEARS ENDED DECEMBER 31	2013			2012			2011
*(in millions)*
Expected income tax expense	$	115.2		$	10.0		$	7.5

Tax difference related to investment disposals and maturities		(17.5	)		(14.3	)		(9.7	)
Effect of foreign operations		(10.8	)		(3.5	)		(1.5	)
Dividend received deduction		(2.5	)		(2.8	)		(1.1	)
Tax-exempt interest		(1.7	)		(1.5	)		(2.0	)
Nondeductible expenses		1.1			2.8			4.7
Change in foreign tax rate		(0.7	)		(0.4	)		—
Change in valuation allowance		—			(7.7	)		(7.5	)
Other, net		0.3			—			(0.3	)

Income tax expense (benefit)	$	83.4		$	(17.4	)	$	(9.9	)

Effective tax rate		25.3	%		(60.6	)%		(45.8	)%

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


DECEMBER 31	2013		2012
*(in millions)*
Deferred tax assets
Loss, LAE and unearned premium reserves, net	$	185.0	$	190.6
Tax credit carryforwards		123.1		126.8
Operating loss carryforwards		64.5		75.1
Employee benefit plans		38.2		56.4
Deferred Lloyd’s underwriting losses		—		13.5
Other		74.9		60.7

		485.7		523.1

Less: Valuation Allowance		2.9		—

		482.8		523.1

Deferred tax liabilities
Deferred acquisition costs		123.5		115.8
Software capitalization		30.1		31.4
Deferred Lloyd’s underwriting income		13.8		—
Investments, net		8.4		43.3
Deferred foreign sourced income		5.1		8.0
Other		62.2		57.0

		243.1		255.5

Net deferred tax asset	$	239.7	$	267.6

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, 2013 are assets of $42.1 million related to U.S. net operating loss carryforwards and a deferred tax asset of $22.4 million related to foreign net operating carryforwards. The pre-tax U.S. operating loss carryforwards of $120.3 million will expire beginning in 2031. The pre-tax foreign operating loss carryforwards of $66.2 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.

Included in the Company’s deferred tax asset as of December 31, 2013 are assets of $110.3 million related to alternative minimum tax credit carryforwards and $12.8 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 2022. 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, it is more likely than not that the remaining deferred tax assets will be realized.

During 2013, the Company recorded a valuation allowance of $2.9 million related to its deferred tax asset on the unrealized depreciation in its investment portfolio. It is the Company’s opinion that it is more likely than not that this asset will not be realized and accordingly, the Company recorded this valuation allowance as an adjustment to other comprehensive income.

In prior years, the Company completed several transactions which resulted in the realization, for tax purposes only, of unrealized gains in its investment portfolio. The Company realized $69.6 million and $98.4 million, respectively, in 2012 and 2011 as a result of such transactions. These transactions enabled the Company to realize capital loss carryforwards to offset these gains, and resulted in the release of the valuation allowance the Company held against the deferred tax asset related to these capital loss carryforwards. In 2012, the Company released $24.4 million of its valuation allowance which was recorded as a benefit in accumulated other comprehensive income. In 2011, the Company released $29.0 million of its valuation allowance which $0.2 million was reflected in income from continuing operations and the remaining $28.8 million was reflected as a benefit in accumulated other comprehensive income. During 2013, 2012 and 2011, the Company recognized in income from continuing operations, related to non-operating income, $17.5 million, $14.3 million and $9.7 million, respectively. The remaining amount of $107.7 million in accumulated other comprehensive income will be released into income from continuing operations 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.

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.

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 indefinitely 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 $20.3 million, $10.0 million and $4.2 million of non-U.S. income for 2013, 2012 and 2011, respectively. However, in the future, if such earnings were distributed to the Company, taxes of $13.0 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 indefinitely reinvested overseas, assuming all foreign tax credits are realized.

The table below provides a reconciliation of the beginning and ending liability for uncertain tax position as follows:


YEARS ENDED DECEMBER 31	2013			2012		2011
*(in millions)*
Liability at beginning and end of year, net	$	0.8		$	0.8	$	0.8
Additions for tax positions of prior years		5.4			—		—
Deferred deductions		(4.8	)		—		—

Liability at end of year, net	$	1.4		$	0.8	$	0.8

The IRS audits of the years 2007 and 2008 commenced in April 2010. In 2011, the Company received a Revenue Agent Report for the 2007 and 2008 IRS audit. The Company agreed to all proposed adjustments other than the disallowance of deduction for certain loss reserves, for which it filed a formal protest. In December 2013, the Company reached a tentative settlement on the disallowance of deduction for certain loss reserves and as a result a liability for uncertain tax positions was established for $4.8 million, with an offsetting deferred tax asset. The Company expects to reach a final settlement of this issue during 2014.

The ultimate deductibility of the aforementioned $4.8 million payable is highly certain, but there is uncertainty about the timing of such deductibility. Because of the impact of deferred tax accounting, other than interest and penalties, a change in the timing of deductions would not impact the annual effective tax rate. 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.

The Company recognizes interest and penalties related to unrecognized tax benefits in federal income tax expense. The Company had accrued interest of $1.2 million and $0.4 million as of December 31, 2013 and 2012, 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. 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 2010.