INCOME TAXES

Income tax expense differs from the amount of income tax determined by applying the United States statutory federal income tax rate of 35% to pre-tax income due to the following:



	UNS Energy									TEP
	Years Ended December 31,
	2013			2012			2011			2013			2012			2011
	Millions of Dollars
Federal Income Tax Expense at Statutory Rate	$	65		$	51		$	62		$	52		$	37		$	48
State Income Tax Expense, Net of Federal Deduction	8			7			8			7			5			6
Federal/State Tax Credits	(2		)	(1		)	(3		)	(2		)	(1		)	(2		)
Allowance for Equity Funds Used During Construction	(2		)	(1		)	(1		)	(1		)	(1		)	(1		)
Deferred Tax Asset Valuation Allowance	—			—			—			2			—			—
Investment Tax Credit Basis Adjustment - Creation of Regulatory Asset	(11		)	—			—			(11		)	—			—
Other	—			—			1			1			(1		)	1
Total Federal and State Income Tax Expense	$	58		$	56		$	67		$	48		$	39		$	52

Investment Tax Credit Basis Adjustment - Creation of Regulatory Asset

Renewable energy assets are eligible for investment tax credits. We reduce the income tax basis of those qualifying assets by half of the related investment tax credit. Historically, the difference between the income tax basis of the asset and the book basis under GAAP was recorded as a deferred tax liability with an offsetting charge to income tax expense in the year the qualifying asset was placed in service. In June 2013, we recorded a regulatory asset and corresponding reduction of income tax expense of $11 million to recover previously recorded income tax expense through future rates as a result of the 2013 TEP Rate Order. The regulatory asset will be amortized as income tax expense as the qualifying assets are depreciated.

Income tax expense included in the income statements consists of the following:



	UNS Energy									TEP
	Years Ended December 31,
	2013			2012			2011			2013			2012			2011
	Millions of Dollars
Current Tax Expense (Benefit):
Federal	$	(11	)	$	(2	)	$	(7	)	$	(8	)	$	(4	)	$	(5	)
State	(2		)	(2		)	(2		)	(2		)	(2		)	(2		)
Total Current Tax Expense (Benefit)	(13		)	(4		)	(9		)	(10		)	(6		)	(7		)
Deferred Tax Expense (Benefit):
Federal	61			51			64			47			38			50
Federal Investment Tax Credits	(1		)	—			(1		)	(1		)	—			(1		)
State	11			9			13			12			7			10
Total Deferred Tax Expense (Benefit)	71			60			76			58			45			59
Total Federal and State Income Tax Expense	$	58		$	56		$	67		$	48		$	39		$	52

The significant components of deferred income tax assets and liabilities consist of the following:



	UNS Energy						TEP
	December 31,						December 31,
	2013			2012			2013			2012
	Millions of Dollars
Gross Deferred Income Tax Assets:
Capital Lease Obligations	$	127		$	141		$	127		$	141
Net Operating Loss Carryforwards	94			72			104			85
Customer Advances and Contributions in Aid of Construction	33			34			19			19
Alternative Minimum Tax Credit	43			43			24			24
Accrued Postretirement Benefits	23			23			23			23
Renewable Energy Credit Up-Front Incentive Payments	—			26			—			20
Emission Allowance Inventory	10			10			10			10
Unregulated Investment Losses	7			9			—			—
Other	50			44			44			43
Total Gross Deferred Income Tax Assets	387			402			351			365
Deferred Tax Assets Valuation Allowance	(7		)	(7		)	(2		)	—
Gross Deferred Income Tax Liabilities:
Plant – Net	(708		)	(648		)	(615		)	(571		)
Capital Lease Assets – Net	(47		)	(34		)	(47		)	(34		)
Pensions	(21		)	(23		)	(22		)	(24		)
PPFAC	(5		)	(6		)	(2		)	(3		)
Other	(21		)	(15		)	(20		)	(15		)
Total Gross Deferred Income Tax Liabilities	(802		)	(726		)	(706		)	(647		)
Net Deferred Income Tax Liabilities	$	(422	)	$	(331	)	$	(357	)	$	(282	)

The net deferred income tax liability on the balance sheet is as follows:



	UNS Energy						TEP
	December 31,						December 31,
	2013			2012			2013			2012
	Millions of Dollars
Deferred Income Taxes – Current Assets	$	60		$	34		$	64		$	37
Deferred Income Taxes – Noncurrent Liabilities	(482		)	(365		)	(421		)	(319		)
Net Deferred Income Tax Liability	$	(422	)	$	(331	)	$	(357	)	$	(282	)

The unregulated investment loss deferred tax asset includes $7 million of capital loss at December 31, 2013 and December 31, 2012. The deferred tax asset can only be used if the company has capital gains to offset the losses. Management believes that it is more likely than not that the company will not be able to generate future capital gains. As a result, UNS Energy recorded a $7 million valuation allowance against the deferred tax asset as of December 31, 2013, and December 31, 2012. Management believes that based on its historical pattern of taxable income, UNS Energy will produce sufficient income in the future to realize all other deferred income tax assets. TEP has recorded a $2 million valuation allowance against state tax credit carryforward deferred tax assets at December 31, 2013. Management believes TEP will not produce sufficient taxable income to use all state tax credits before they expire.

Income Tax Position

As of December 31, 2013, UNS Energy and TEP had the following carryforward amounts:



	UNS Energy			TEP
	Amount		Expiring Year	Amount		Expiring Year
	Millions of Dollars			Millions of Dollars
Capital Loss	$	7	2015	$	—	N/A
Federal Net Operating Loss	266		2031-33	286		2031-33
State Net Operating Loss	30		2032-33	99		2016-33
State Credits	5		2016-18	6		2016-18
Alternative Minimum Tax Credit	43		None	24		None
Investment Tax Credits	6		2032-33	6		2032-33

If the pending Merger is approved there would be an annual limitation on the amount of carryforwards that can be utilized.

Excess Tax Benefit Realized from Share-Based Compensation Plans

UNS Energy records excess tax benefits as an increase to Common Stock when tax deductions for share-based compensation exceed the expense recorded in the financial statements and they result in a reduction to income taxes payable. As of December 31, 2013, UNS Energy had $4 million of excess tax benefits that were not recorded in Common Stock. The excess benefits will be recorded in Common Stock when the Federal net operating loss carryforwards of $266 million are used.

Uncertain Tax Positions

A reconciliation of the beginning and ending balances of unrecognized tax benefits follows:



	UNS Energy						TEP
	December 31,						December 31,
	2013			2012			2013			2012
	Millions of Dollars
Unrecognized Tax Benefits, Beginning of Year	$	30		$	29		$	23		$	24
Additions Based on Tax Positions Taken in the Current Year	2			5			1			3
Reductions of Positions from Prior Year Based on Tax Authority Ruling	(28		)	(4		)	(22		)	(4		)
Unrecognized Tax Benefits, End of Year	$	4		$	30		$	2		$	23

Unrecognized tax benefits, if recognized, would not reduce income tax expense at December 31, 2013. Unrecognized tax benefits, if recognized, would reduce income tax expense by $1 million at December 31, 2012 for both UNS Energy and TEP.

UNS Energy and TEP recognized a $1 million reduction to interest expense in 2013 and no reduction in 2012. UNS Energy and TEP had no interest payable balance at December 31, 2013 and $1 million at December 31, 2012. We have no penalties accrued in the years presented.

In February 2013, we received a favorable ruling from the Internal Revenue Service (IRS) allowing us to deduct up-front incentive payments to customers who install renewable energy resources. These customers transfer environmental attributes or RECs associated with their renewable installations to us over the expected life of the contract for an up-front incentive payment based on the generating capacity of their installation. As a result of the IRS ruling in the first quarter of 2013, UNS Energy reduced unrecognized tax benefits by $28 million, and TEP reduced unrecognized tax benefits by $22 million. The changes in tax benefits primarily affected the balance sheets.

UNS Energy and TEP have been audited by the IRS through tax year 2010 and the IRS has provided notice of intent to audit the 2011 tax returns. UNS Energy and TEP are not currently under audit by any state tax agencies. The balance in unrecognized tax benefits could change in the next 12 months as a result of ongoing IRS audits, but we are unable to determine the amount of change.

Tangible Property Regulations

In September 2013, the U.S. Treasury Department released final income tax regulations on the deduction and capitalization of expenditures related to tangible property. These final regulations apply to tax years beginning on or after January 1, 2014. Several of the provisions within the regulations will require a tax accounting method change to be filed with the IRS resulting in a cumulative effect adjustment. The adoption of these regulations by UNS Energy and TEP resulted in a $4 million increase to plant-related deferred tax liabilities and net operating loss deferred tax assets at December 31, 2013.