L. Income Taxes

The following is a reconciliation of income taxes at the statutory rate of 35% and income taxes as shown in the Statement of Earnings (in millions):



	2012			2011			2010
Earnings before income taxes	$	537		$	558		$	694

Income taxes at statutory rate	$	188		$	195		$	243
Effect of:
Tax case and settlement of open tax years	(67		)	—			—
Change in valuation allowance	3			44			(1		)
Losses of managed investment entities	34			9			23
Goodwill impairment charge	—			—			8
Subsidiaries not in AFG’s tax return	(3		)	5			6
Tax exempt interest	(23		)	(23		)	(16		)
Other	3			9			5
Provision for income taxes as shown on the Statement of Earnings	$	135		$	239		$	268

AFG was involved in litigation with the IRS regarding the calculation of tax reserves for certain annuity liabilities pursuant to Actuarial Guideline 33. In 2010, the U.S. District Court in Southern Ohio issued a final summary judgment in favor of AFG. The IRS appealed the District Court decision to the Sixth Circuit Court of Appeals, which heard oral arguments on March 7, 2012. On May 4, 2012, the Sixth Circuit Court of Appeals affirmed the summary judgment of the District Court in favor of AFG. On August 2, 2012, the 90 day period for the IRS to seek a discretionary appeal of the Sixth District Court of Appeals decision in this case expired and the decision in favor of AFG became final. As a result, during the third quarter of 2012, AFG recorded net earnings of approximately $28 million, which included the expected refund of $17 million of tax and interest paid to the IRS in 2005 and 2006 as well as a decrease in the liability for uncertain tax positions. In December 2012, AFG reached an agreement with the IRS to close subsequent years held open by the tax case. As a result, AFG decreased its tax liabilities by approximately $39 million in the fourth quarter of 2012.

AFG’s 2008 — 2012 tax years remain subject to examination by the IRS.

Total earnings before income taxes include losses subject to tax in foreign jurisdictions of $5 million in 2012, $31 million in 2011 and $12 million in 2010.

The total income tax provision (credit) consists of (in millions):



	2012			2011		2010
Current taxes:
Federal	$	146		$	186	$	214
State	6			4		4
Foreign	—			—		(1		)
Deferred taxes:
Federal	(17		)	22		65
Foreign	—			27		(14		)
Provision for income taxes	$	135		$	239	$	268

For income tax purposes, AFG and its subsidiaries had the following carryforwards available at December 31, 2012 (in millions):



	Expiring	Amount
Operating Loss – U.S.	2013 — 2020	$	74
	2021 — 2025	72
Operating Loss – United Kingdom	indefinite	116

Deferred income tax assets and liabilities reflect temporary differences between the carrying amounts of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. The significant components of deferred tax assets and liabilities included in the Balance Sheet at December 31 were as follows (in millions):



	2012			2011
Deferred tax assets:
Federal net operating loss carryforwards	$	51		$	51
Foreign underwriting losses	46			42
Insurance claims and reserves	528			431
Employee benefits	91			94
Other, net	36			52
Total deferred tax assets before valuation allowance	752			670
Valuation allowance against deferred tax assets	(101		)	(97		)
Total deferred tax assets	651			573
Deferred tax liabilities:
Subsidiaries not in AFG’s tax return	(58		)	(61		)
Investment securities	(753		)	(441		)
Deferred policy acquisition costs	(91		)	(204		)
Total deferred tax liabilities	(902		)	(706		)
Net deferred tax liability	$	(251	)	$	(133	)

AFG’s net deferred tax liability at December 31, 2012 and 2011 is included in other liabilities in AFG’s Balance Sheet.

The likelihood of realizing deferred tax assets is reviewed periodically; any adjustments required to the valuation allowance are made in the period during which developments requiring an adjustment become known.

“Foreign underwriting losses” in the table above include the net operating loss carryforward and other deferred tax assets related to the Marketform Lloyd’s insurance business, which resulted primarily from underwriting losses in its run-off Italian public hospital medical malpractice business that has not been written since 2008. During the fourth quarter of 2011, AFG recorded losses in other lines written by its Lloyd’s insurance business. Net operating losses can be carried forward indefinitely to offset future taxable income in the United Kingdom, and management expects these businesses to produce underwriting profits in future years. Nevertheless, because the Marketform Lloyd’s insurance business was in a cumulative loss position for the three years ended December 31, 2011, and the fourth quarter 2011 losses were not limited to the run-off Italian public hospital medical malpractice business, there was uncertainty concerning the realization of the deferred tax benefits associated with the losses. Accordingly, AFG recorded a $44 million valuation allowance against the deferred tax assets related to the Lloyd’s insurance business in 2011, approximately $34 million of which related to prior year losses. AFG will be able to reduce this valuation allowance in future periods when income is generated by the Lloyd’s business.

In addition to the valuation allowance related to the Marketform Lloyd’s insurance business discussed above, the gross deferred tax asset has also been reduced by a $50 million valuation allowance related to a portion of AFG’s net operating loss carryforwards (“NOL”) that is subject to the separate return limitation year (“SRLY”) tax rules. A SRLY NOL can be used only by the entity that created it and only in years that the consolidated group has taxable income.

The changes in the deferred tax liabilities related to investment securities and deferred policy acquisition costs at year end 2012 compared to 2011 are due primarily to the increase in unrealized gains on fixed maturity securities. The decline in the deferred tax liability related to deferred policy acquisition costs also reflects the fourth quarter 2012 write-off of DPAC in AFG’s closed block of long-term care insurance.

AFG increased its liability for uncertain tax positions by $3 million in 2012, $7 million in 2011 and $16 million in 2010, exclusive of interest, to reflect uncertainty as to the timing of tax return inclusion of income related to certain securities. Because the ultimate recognition of income with respect to these securities is highly certain, any adjustments to this liability will result in offsetting adjustments to AFG’s deferred tax liability. Accordingly, the ultimate resolution of this item will not impact AFG’s annual effective tax rate but could accelerate the payment of taxes. During 2012, AFG also increased its liability for uncertain tax positions by $2 million related to the deductibility of certain financing expenses.

The resolution of the tax case and closure of subsequent tax years during 2012 (discussed above) reduced AFG’s liability for uncertain tax positions by $36 million and the related liability for interest by $14 million. Additionally, the IRS issued new guidance during the third quarter of 2012 that brought certainty to the timing of investment deductions, which caused AFG to reduce its liability for uncertain tax positions by $10 million. Because this was solely a timing issue, the reduction in AFG’s liability for uncertain tax positions for this item was offset by an increase in AFG’s deferred tax liability with no overall impact on income tax expense.

A progression of the liability for uncertain tax positions, excluding interest and penalties, follows (in millions):



	2012			2011		2010
Balance at January 1	$	59		$	52	$	36
Reductions for tax positions of prior years	(46		)	—		—
Additions for tax positions of current year	5			7		16
Balance at December 31	$	18		$	59	$	52

The total unrecognized tax benefits and related interest that, if recognized, would impact the effective tax rate is $3 million at December 31, 2012. AFG’s provision for income taxes included a benefit of $14 million in 2012 and expense of $3 million in 2011 and $2 million in 2010 of interest (net of federal benefit or expense). AFG’s liability for interest related to unrecognized tax benefits was $1 million at December 31, 2012 and $15 million at December 31, 2011 (net of federal benefit); no penalties were accrued at those dates.

Cash payments for income taxes, net of refunds, were $277 million, $157 million and $196 million for 2012, 2011 and 2010, respectively.