Income Taxes

6 Months Ended

Jun. 30, 2011

Income Taxes [Abstract]

INCOME TAXES

NOTE 5. INCOME TAXES

For the three and six months ended June 30, 2011 and June 30, 2010, the effective tax rate differed from the federal rate, primarily due to state income taxes. In addition, the effective rate for the quarter ended June 30, 2010 was impacted by the domestic production activities deduction and an increase in the valuation allowance relating to a capital loss from Millennium’s sale of Nations Energy Corporation.

Valuation Allowance and Capital Loss on Sale of Nations Energy Corporation (Nations Energy)

In the first quarter of 2010, UniSource Energy recorded a $12 million capital loss for tax purposes from Millennium’s sale of Nations Energy. UniSource Energy has a $5 million deferred tax asset as a result of the capital loss. Since UniSource Energy’s deferred tax assets related to the investment in Nations Energy, net of valuation allowance, were $3 million at the time of the sale, a $2 million deferred tax asset was recorded. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion, or the entire deferred tax asset will not be realized. For the six months ended June 30, 2010, a $3 million valuation allowance was recorded because management believes that only $2 million of the deferred tax asset may be realized due to the five-year capital loss carryforward limitation.

State Tax Rate Change

Deferred tax assets and liabilities are recorded using income tax rates expected to be in effect when the deferred tax assets and liabilities are realized or settled. In the first quarter of 2011, the Arizona legislature passed a bill reducing the corporate income tax rate from the current rate of 6.968%. The tax rate reduction will be phased in beginning in 2014 with a reduction of approximately 0.5% per year until the income tax rate reaches 4.9% for 2017 and later years. As a result of these tax rate reductions, net deferred tax liabilities at UniSource Energy and TEP were reduced by $13 million offset entirely by adjustments to regulatory assets and liabilities. The income tax rate change will not have an impact on UniSource Energy’s and TEP’s effective tax rate for 2011.

Uncertain Tax Positions

As a result of a change in accounting method approved by the Internal Revenue Service in the second quarter of 2011, the balance of unrecognized tax benefits decreased by $13 million for UniSource Energy and $10 million for TEP. The decrease in unrecognized tax benefits had no impact on income tax expense. The adjustment decreased Other in Deferred Credits and Other Liabilities and increased Deferred Income Taxes — Noncurrent on the balance sheet.