Income Taxes

9 Months Ended

Sep. 30, 2012

Income Taxes

Income Taxes

NOTE 10. Income Taxes

The Company and its Bermuda-domiciled subsidiary are not subject to Bermuda income tax under current Bermuda law. In the event that there is a change in the current law such that taxes are imposed, the Company and its Bermuda-domiciled subsidiary would be exempt from such tax until March 31, 2035, pursuant to the Bermuda Exempted Undertakings Tax Protection Act of 1966.  The Company also has subsidiaries that operate in Gibraltar, Luxembourg and the United States. U.S. operations are financed with a combination of debt and equity and the financing income currently accounts for the majority of non-U.S. income.

OneBeacon’s income tax expense related to pre-tax income from continuing operations for the three months ended September 30, 2012 and 2011 represented net effective tax rates of 24.0% and (48.1)%, respectively. The net effective tax rates for the nine months ended September 30, 2012 and 2011 were 20.2% and 4.0%, respectively. The effective tax rates for the three and nine months ended September 30, 2012 were lower than the U.S. statutory rate of 35% due to income generated in jurisdictions other than the United States, principally representing interest income taxed in a jurisdiction with a lower effective tax rate. The effective tax rate for the three months ended September 30, 2011 was higher than the U.S. statutory rate of 35% due to a pre-tax loss from U.S. operations and income generated in jurisdictions other than the United States, principally representing interest income taxed in a jurisdiction with a lower effective tax rate. The effective tax rate for the nine months ended September 30, 2011 was lower than the U.S. statutory rate of 35% due to income generated in jurisdictions other than the United States, principally representing interest income taxed in a jurisdiction with a lower effective tax rate. For the three months ended September 30, 2012 and 2011, the effective tax rate on non-U.S. income was 0.7% and 4.1%, respectively, and the effective tax rate on U.S. (loss) income was 37.4% and (30.9)%, respectively. For the nine months ended September 30, 2012 and 2011, the effective tax rate on non-U.S. income was 0.7% and 2.9%, respectively, and the effective tax rate on U.S. income (loss) was 34.0% and (6.5)%, respectively.

In arriving at the effective tax rate for the three and nine months ended September 30, 2012 and 2011, OneBeacon forecasted changes in realized and unrealized investment gains or losses for the years ending December 31, 2012 and 2011, respectively, and included these gains or losses in the effective tax rate calculation pursuant to ASC 740-270.

OneBeacon classifies all interest and penalties on unrecognized tax benefits as part of income tax expense. With few exceptions, OneBeacon is no longer subject to U.S. federal, state or non-U.S. income tax examinations by tax authorities for years before 2005. In October 2008, the IRS commenced examination of OneBeacon’s U.S. income tax returns for 2005 and 2006. On January 5, 2011, OneBeacon received a revised Form 4549-A (Income Tax Discrepancy Adjustments) from the IRS relating to the examination of tax years 2005 and 2006. The estimated total assessment, including interest and utilization of alternative minimum and foreign tax credit carryovers, is $20.6 million. OneBeacon disagrees with the adjustments proposed by the IRS and intends to defend its position. The timing of the resolution of these issues is uncertain, however, it is reasonably possible that the resolution could occur within the next twelve months. An estimate of the range of potential outcomes cannot be made at this time. When ultimately settled, OneBeacon does not expect the resolution of this examination to result in a material change to its financial position.

On July 28, 2011, the IRS commenced an examination of OneBeacon’s U.S. income tax returns for 2007, 2008 and 2009. OneBeacon does not expect the resolution of this examination to result in a material change to its financial position.

Upon completion of the Runoff Transaction, it is expected that the unrecognized tax benefits associated with tax positions where the deductibility is certain but the timing is uncertain, will decrease by approximately $11.5 million.  OneBeacon does not expect the decrease to result in a material change to its financial position.

On January 24, 2012, OneBeacon sold the issued and outstanding shares of common stock of OB Lux to White Sands for $24.7 million. See Note 2. As a result of this sale, the Luxembourg NOLs generated by OB Lux of $1,031.7 million are no longer available for use by OneBeacon. As discussed in “Note 7. Income Taxes” of the Company’s 2011 Annual Report on Form 10-K, there was a full valuation allowance recorded against the tax benefit of these NOLs.