INCOME TAXES

9 Months Ended

Sep. 30, 2012

INCOME TAXES

INCOME TAXES

14. INCOME TAXES

Interim Tax Calculation Method

AIG uses the estimated annual effective tax rate method in computing its interim tax provision. Certain items, including those deemed to be unusual, infrequent or that cannot be reliably estimated, are excluded from the estimated annual effective tax rate. In these cases, the actual tax expense or benefit applicable to those items is treated discretely, and is reported in the same period as the related item. For the three- and nine-month periods ended September 30, 2012, the tax effects of the gains on ML II and certain dispositions, including a portion of the ordinary shares of AIA and common units of The Blackstone Group L.P., as well as certain actual gains on AIG Life and Retirement's available-for-sale securities, were treated as discrete items. Those changes in the valuation allowance, which were reflected in the three- and nine-month periods ended September 30, 2012, were also treated as discrete items.

Interim Tax Expense (Benefit)

For the three- and nine-month periods ended September 30, 2012, the effective tax rates on pretax income from continuing operations were 28.3 and 14.4 percent, respectively. The effective tax rates for the three- and nine-month periods ended September 30, 2012, attributable to continuing operations differ from the statutory tax rate of 35 percent primarily due to tax effects associated with tax exempt interest income and investments in partnerships, adjustments to the tax bases of certain foreign aircraft leases, and a decrease in the life-insurance-business capital loss carryforward valuation allowance. These items were partially offset by changes in uncertain tax positions.

For the three- and nine-month periods ended September 30, 2011, the effective tax rates on pretax loss from continuing operations were 15.6 and 31.3 percent, respectively. The tax benefit was primarily due to a decrease in the valuation allowance attributable to the anticipated inclusion of the ALICO SPV within the U.S. consolidated income tax group, tax effects associated with tax exempt interest income, investments in partnerships, and effective settlements of certain uncertain tax positions, partially offset by an increase in the valuation allowance attributable to continuing operations.

For the nine-month period ended September 30, 2011, the entire increase in the U.S. consolidated income tax group valuation allowance was allocated to continuing operations. The amount allocated to continuing operations was net of the decrease to the valuation allowance attributable to the anticipated inclusion of the ALICO SPV within the U.S. consolidated income tax group.

Assessment of Deferred Tax Asset Valuation Allowances

The evaluation of the recoverability of AIG's deferred tax asset and the need for a valuation allowance requires AIG to weigh all positive and negative evidence to reach a conclusion that it is more likely than not that all or some portion of the deferred tax asset will not be realized. The weight given to the evidence is commensurate with the extent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is necessary and the more difficult it is to support a conclusion that a valuation allowance is not needed.

AIG's framework for assessing the recoverability of the deferred tax assets requires AIG to consider all available evidence, including:

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the nature, frequency, and amount of cumulative financial reporting income and losses in recent years;

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the sustainability of recent operating profitability of AIG's subsidiaries;

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the predictability of future operating profitability of the character necessary to realize the net deferred tax asset;

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the carryforward period for the capital loss carryforwards, including the effect of reversing taxable temporary differences; and

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prudent and feasible actions and tax planning strategies that would be implemented, if necessary, to protect against the loss of the deferred tax assets.

As a result of sales in the ordinary course of business to manage the investment portfolio and the application of prudent and feasible tax planning strategies, during the nine months ended September 30, 2012, AIG determined that an additional portion of the life insurance business capital loss carryforwards will more-likely-than-not be realized prior to their expiration.

As a result, AIG released an additional $177 million of the deferred tax asset valuation allowance associated with the life insurance business capital loss carryforwards during the three-month period ended September 30, 2012, all of which was allocated to income from continuing operations. For the nine-month period ended September 30, 2012, AIG released $1.7 billion of its deferred tax asset valuation allowance associated with the life insurance business capital loss carryforwards, of which $1.6 billion was allocated to income from continuing operations. Additional life insurance business capital loss carryforwards may be realized in the future if and when other prudent and feasible tax planning strategies are identified. Changes in market conditions, including rising interest rates above AIG's projections, may result in a reduction in projected taxable gains and reestablishment of a valuation allowance.

Accounting for Uncertainty in Income Taxes

At September 30, 2012 and December 31, 2011, AIG's unrecognized tax benefits, excluding interest and penalties, were $4.4 billion and $4.3 billion, respectively. The increase in AIG's unrecognized tax benefits, excluding interest and penalties, was primarily due to adjustments to tax bases of certain foreign aircraft leases and foreign tax credits associated with cross border financing transactions. At September 30, 2012 and December 31, 2011, AIG's unrecognized tax benefits included $0.2 billion and $0.7 billion, respectively, related to tax positions that if recognized would not affect the effective tax rate because they relate to the timing, rather than the permissibility, of the deduction. Accordingly, at September 30, 2012 and December 31, 2011, the amounts of unrecognized tax benefits that, if recognized, would favorably affect the effective tax rate were $4.2 billion and $3.6 billion, respectively.

Interest and penalties related to unrecognized tax benefits are recognized in income tax expense. At September 30, 2012 and December 31, 2011, AIG accrued $929 million and $744 million, respectively, for the payment of interest (net of the federal benefit) and penalties. For the nine-month periods ended September 30, 2012 and 2011, AIG recognized $185 million and $(58) million, respectively, of income tax expense (benefit) for interest net of the federal benefit (expense) and penalties.

Although it is reasonably possible that a change in the balance of unrecognized tax benefits may occur within the next twelve months, at this time it is not possible to estimate the range of the change due to the uncertainty of the potential outcomes.