15. Income Taxes

Prior to the separation from Loews in 2008 (the “Separation”), Lorillard was included in the Loews consolidated federal income tax return, and federal income tax liabilities were included on the balance sheet of Loews. Under the terms of the pre-Separation Tax Allocation Agreement between Lorillard and Loews, Lorillard made payments to, or was reimbursed by Loews for the tax effects resulting from its inclusion in Loews’ consolidated federal income tax return. As of December 31, 2013, there were no tax obligations between Lorillard and Loews for periods prior to the Separation. Following the Separation, Lorillard and its eligible subsidiaries filed a stand-alone consolidated federal income tax return.

The Separation Agreement with Loews (the “Separation Agreement”) requires Lorillard (and any successor entity) to indemnify Loews for any losses resulting from the failure of the Separation to qualify as a tax-free transaction (except if the failure to qualify is solely due to Loews’ fault). This indemnification obligation applies regardless of whether Lorillard or a potential acquirer obtains a supplemental ruling or an opinion of counsel.

The Separation Agreement further provides for cooperation between Lorillard and Loews with respect to additional tax matters, including the exchange of information and the retention of records which may affect the income tax liability of the parties to the Separation Agreement.

The provision (benefit) for income taxes consisted of the following:


	Year Ended December 31,
	2013			2012			2011
	(In millions)
Current
Federal	$	606		$	530		$	548
State		140			111			120
Foreign		—			—			—
Deferred
Federal		(36	)		(10	)		(10	)
State		(5	)		(2	)		(4	)
Foreign		(1	)		—			—

Total	$	704		$	629		$	654

Pre-tax income (loss) for domestic and foreign operations is as follows:


(In millions)	2013			2012		2011
Domestic	$	1,891		$	1,728	$	1,770
Foreign		(7	)		—		—

	$	1,884		$	1,728	$	1,770

Total income tax expense for the years ended December 31, 2013, 2012, and 2011 was different than the amounts of $659 million, $605 million, and $620 million, computed by applying the statutory U.S. federal income tax rate of 35% to income before taxes for each of the years.

A reconciliation between the statutory federal income tax rate and Lorillard’s effective income tax rate as a percentage of income is as follows:


	2013			2012			2011
Statutory rate		35.0	%		35.0	%		35.0	%
Increase (decrease) in rate resulting from:
State taxes		4.7			4.1			4.3
Domestic manufacturer’s deduction		(2.7	)		(2.8	)		(2.4	)
Other		0.4			0.1			0.1

Effective rate		37.4	%		36.4	%		37.0	%

Deferred tax assets (liabilities) are as follows:


	December 31,
(In millions)	2013			2012
Deferred tax assets:
Employee benefits	$	137		$	161
Settlement costs		525			511
State and local income taxes		22			18
Litigation and legal		24			6
Inventory		3			4
Other		3			2

Gross deferred tax assets		714			702

Deferred tax liabilities:
Depreciation		(66	)		(63	)
Federal effect of state deferred taxes		(42	)		(34	)

Gross deferred tax liabilities		(108	)		(97	)

Net deferred tax assets	$	606		$	605

A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:


(In millions)	2013			2012			2011
Balance at January 1,	$	41		$	42		$	33
Additions for tax positions of prior years		4			4			6
Reductions for tax positions of prior years		(2	)		(6	)		(2	)
Additions based on tax positions related to the current year		10			9			9
Settlements		—			(4	)		(1	)
Lapse of statute of limitations		(1	)		(4	)		(3	)

Balance at December 31,	$	52		$	41		$	42

At December 31, 2013, 2012, and 2011, there were $34 million, $27 million, and $28 million, respectively, of tax benefits that, if recognized, would affect the effective tax rate.

Lorillard recognizes interest related to unrecognized tax benefits and tax refund claims in interest expense and recognizes penalties (if any) in income tax expense. During the years ended December 31, 2013, 2012, and 2011, Lorillard recognized an expense of approximately $2 million, $2 million, and $2 million in interest and penalties. Lorillard had accrued interest and penalties related to unrecognized tax benefits of $19 million and $16 million at December 31, 2013 and 2012, respectively.

Due to the potential for resolution of certain tax examinations and the expiration of various statutes of limitation, it is reasonably possible that Lorillard’s gross unrecognized tax benefits balance may decrease by approximately $12 million in the next twelve months.

Lorillard and/or one or more of its subsidiaries file income tax returns in the U.S. federal jurisdiction and various foreign, state and city jurisdictions. Lorillard’s consolidated federal income tax returns for the periods after 2009 are subject to IRS examination, with 2011 currently under examination by the Internal Revenue Service. With few exceptions, Lorillard’s state, local or foreign tax returns are subject to examination by taxing authorities for years after 2008.